China A-shares to go into MSCI index?

China A-shares could shortly be included in a key international index for the first time - in a way that highlights smarter efforts by the West to help China fully integrate into global markets.

This is the view of John Lin, Alliance Bernstein’s Hong Kong-based portfolio manager, who noted that each year since 2014 index provider MSCI has consulted with equity market practitioners on whether the time has been right to admit China A-shares, which are traded on onshore markets, into the MSCI Emerging Market Index.

“To date, the answer has been 'no' - but there are clear signs that this year the answer will be 'yes'. And it is expected this will happen in June 2018," he said. The reason? MSCI has dropped its usual rigorously-applied standard terms of entry in favor of a more gradualist and pragmatic approach.

The move will involve fewer stocks initially, sourced under simpler institutional arrangements than those offered in previous proposals. This is an exciting development, for two reasons, according to Lin.

“First, even a modest initial inclusion in the index will be a significant step forward in bringing China - which has an equity-market capitalization of US$7.5 trillion - fully into global capital markets," he explained. “Second, it suggests that Western companies have taken a leaf out of China’s own book on how to approach the huge challenge of modernizing the country’s capital markets."

China’s capital markets

Currently there are three ways for foreign investors to participate in China A-shares. Two are licensing regimes while the third consists of arm's-length trading arrangements on the Shanghai and Shenzhen stock exchanges.

The Qualified Foreign Institutional Investor (QFII) scheme and the RMB Qualified Foreign Institutional Investor (RQFII) scheme allow direct access to China’s capital markets. Investors are subject to conditions, including licensing requirements, quotas and redemption limitations.

Since 2014 and last December respectively, the Shanghai and Shenzhen stock exchanges have participated in Stock Connect. This program links them to the Hong Kong Stock Exchange and enables foreign investors to buy A-shares with fewer restrictions than under the QFII schemes.

Until this year, Lin noted, MSCI’s proposals to include A-shares in its index were based on the QFII/RQFII framework and 448 stocks. The terms and conditions of the QFII licensing regime, however, were among the obstacles to the market’s acceptance of the proposals. According to the analyst, MSCI seems to have changed its tune.

“Just as China did when pausing for nine years between the launch of QFII and RQFII, and two years between adding the Shanghai and Shenzhen exchanges to Stock Connect, MSCI is taking a 'softly, softly' approach," he argued.

Narrowing the universe

In his view, MSCI will later this year propose to include in the index only A-shares sourced under the Stock Connect regime.

"This narrows the universe of investible stocks but, as Stock Connect is not subject to the same restrictions governing QFII, the proposal, in our view, has a real chance of being accepted," Lin said. “Initially, the 169 stocks envisaged under this proposal would increase China’s presence in the Emerging Market Index by just 50 basis points, to 28.6 per cent. But that’s the thin end of the wedge.

“When the 169 stocks go into the index they will do so at a low initial inclusion factor. The next step will be for MSCI to increase the weightings. This will immediately take the A-shares’ portion of the index from 50 basis points to 8.6 per cent, in our view.”

But it doesn’t stop there, the portfolio manager argued.

“Currently, the total number of shares included in the Stock Connect scheme is 1,479 compared with more than 2,900 available under the QFII system. As Stock Connect grows over time and A-shares become fully included in the index, China’s overall weighting is likely to grow to nearly 40 per cent," he said.

Its share of the MSCI All Country World Index would increase from 3 per cent to 4 per cent, raising it from joint sixth place currently to fourth place behind the US, Japan and the UK - and ahead of France, Canada and Germany.

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