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Prepare for a Wave of Foreign Money Inflows into Chinese Equities This Summer

MSCI has been saying no to China’s A-shares for years. But this year, the index group will finally include China’s A-shares in its MSCI Emerging Markets Index (“MSCI EM index”), marking a watershed moment for the world’s second largest equity market.

China A-shares –- that is, stocks of Chinese companies traded on the mainland’s exchanges, including the Shanghai Stock Exchange and Shenzhen Stock Exchange –- have been on MSCI’s Market Classification Review list since 2013, awaiting sufficient improvements in China’s market accessibility. Apparently, China has improved its accessibility conditions because MSCI plans to add about 236 of China’s domestic large cap stocks to the MSCI EM index starting in June 2018. A-shares may also be included in the MSCI All Country World Index (“MSCI ACWI”).

MSCI’s EM index captures the performance of large and mid-cap stocks across 23 emerging market countries. Only 5% of the market capitalization of the eligible A-share stocks will be included initially, and these shares will carry a weighting of only 0.73% in the MSCI EM. About 27% of the index is already represented by Chinese equities that are traded on foreign exchanges (i.e. non A-shares), so adding these 236 domestic stocks will bring China’s total share of the MSCI EM pie to 28%. Over time, full inclusion of A-shares could bring China’s weight in the index to nearly 45%.

For many investors, this is welcome news, as China is under-represented in global equity indices relative to its economic influence. Despite China accounting for 17% of global GDP, 11% of global trade, and 9% of global consumption, the country has a weighting of just 3.65% in the MSCI All Country World Index. And, because foreign ownership of A-shares have been very limited due to strict quotas set by the Chinese government, foreign investors have not had full access to China’s secular growth sectors, including materials, industrials, consumer discretionary, and healthcare. By including A-shares in the MSCI indexes, investors will be able to gain exposure to sectors of the economy currently under-represented in other share classes.

Moreover, this is all coming at a time when China’s stock market is undervalued, if you go by Warren Buffett’s market indicator which suggests that, if a country’s Total Market Cap/GDP ratio is below 50%, that country’s stock market is significantly undervalued. China’s TMC/GDP ratio is 44%, according to this Global Stock Market Valuations table, and the country’s stock market is expected to return 28.6% a year for the coming years if valuations revert to the mean of 15.42.

The immediate market impact of the MSCI inclusion will be somewhat muted, but the long term implications are bound to be far-reaching. Analysts have estimated that inclusion in the indexes will spur about $8 billion to $10 billion more in fund flows to China’s A-shares. In time, Chinese equities will gain the prominence in global investors’ portfolios that reflects the size of its $14 trillion economy and $8.7 trillion equity market, which accounts for almost a tenth of the global equity market’s value.

The change could also drive portfolio managers to put more weight on emerging market shares as a whole. Currently, global investors only allocate about 10% of their funds to emerging markets; the rest is invested in developed markets. Historically, A-shares have had very different features from conventional emerging market stocks, including exposure to higher growth and lower liquidity risks, so they would add extra diversification to EM portfolios.

Chinese asset managers, seeking to get ahead of the expected wave of foreign money inflows, are racing to launch index funds containing the group of mainland stocks that will be included in MSCI’s emerging market benchmark this year.

Investors interested in gaining exposure to China’s equity market before June can do so via the iShares MSCI China ETF (MCHI).

 

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