The inclusion of China’s A-shares in global and emerging market indices is positive for Chinese equity markets and passive funds such as ETFs, according to a report from Moody’s.

Moody’s remains cautious on Chinese corporate governance following the decision to increase the weight of China A-shares in MSCI’s and FTSE Russell’s EM indices.

In late September, index providers MSCI and FTSE Russell announced increases in exposure to China’s A-shares in their respective emerging markets indices, MSCI Emerging Markets Index and FTSE Emerging Markets Index.

The increase in allocation comes a little over a year after MSCI first included Chinese A-shares in its emerging market index.

MSCI plans to increase the inclusion factor of China A-shares from 5% to 20%, while FTSE Russell intends to begin including A-shares in its index for the first time at an inclusion factor of 25%.

Moody’s suggest that these moves will benefit passive investors by increasing the diversification of funds tracking these indices.

Over $1.9 trillion of assets is linked to MSCI’s EM index which is perhaps the best-known benchmark for EM equity exposure within the ETF industry. The iShares Core MSCI Emerging Markets ETF (IEMG US) and iShares MSCI Emerging Markets ETF (EEM US), for example, house $45.5 billion and $28.0bn in assets respectively. Similarly, FTSE Russell’s EM index serves as the underlying reference index to the $53.5bn Vanguard FTSE Emerging Markets ETF (VWO US) and the $4.5bn Schwab Emerging Markets Equity ETF (SCHE US).

Moody’s predicts that the gradual inclusion of China’s A-shares into these indices will likely result in greater flows into passive EM funds linked to them, such as the ETFs mentioned above, due to investors being able to satisfy their demand for Chinese mainland equity exposure through a single ticker solution.

Moody’s further highlights that the steps towards greater index exposure to Chinese A-shares is also expected to positively impact global capital inflows into China’s equity markets, especially given rising global adoption of low-cost passive index funds such as ETFs. It believes the potential A-shares weight increase could result in more than $66bn of inflows from MSCI-linked products, and $10bn of inflows from FTSE Russell-linked products.

However, although ETFs will benefit from increased investment diversification as a result of greater exposure to China, Moody’s notes that uncertainty remains around the strength and consistency of China’s corporate governance. The credit agency points to a survey in July by the Asian Corporate Governance Association that reported 48% of institutional investors thought it was inappropriate for MSCI to include A-shares in its indices, citing corporate governance concerns as one of the major reasons.

The risks are likely to increase as the scope of A-share inclusion is broadened. FTSE Russell plans to also include small and mid-cap companies, and MSCI plans to phase in the inclusion of stocks from ChiNext in 2019, a tech-heavy board of the Shenzhen Stock Exchange, and China A Mid Cap securities in May 2020.