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Enter the dragon

23 Jan 2018

China’s inclusion in the MSCI Emerging Market index has caused little excitement, but, as Lynn Strongin Dodds explains, there could be longer-term benefits.

“Capital investment has been the key driver of Chinese growth in recent decades but a move to a more consumer driven growth story raises some exciting possibilities and A-Shares offer the potential for more direct exposure to this theme.”

Chris Mellor, Invesco PowerShares
The inclusion of China A-shares into the MSCI Emerging Market fold in the summer was a long time coming, but is not expected to have a dramatic impact on investment habits in the short term. In fact, institutions had begun to increase their exposure as the economy recovered its equilibrium and the government continued to improve corporate governance. “In many ways I would say that the inclusion of A-shares is less important other than as a gesture,” says Kim Catechis, head of global emerging markets at Martin Currie. He points to the launch of American Deposit Receipts (ADRs) in New York more than 10 years ago as much more meaningful because as we saw with Alibaba (which had a record $25bn initial public offering in 2015), it has a bigger market cap and is fully trading. “The A share inclusion initially will only account for roughly 0.73% of the MSCI EM (which is tracked by an estimated $1.6trn in assets),” Catechis adds. The index will include 222 mainland China-based companies which will be quoted in renminbi and listed on either the Shanghai or Shenzhen stock exchanges. While they only comprise 5.5% of the $7.3trn Chinese A-share market, the consensus is that they represent a much broader picture of China’s real economy than the MSCI China Index, which provides exposure to large overseas listings of Chinese banks and internet companies. By contrast, A-shares cover industrials, health care, consumer staples, materials, IT, telecommunications and energy plus several companies that are absent from the offshore universe. These range from household furnishings to chemicals, renewable power producers, biotech and pharmaceutical companies. The expectation, of course, is that the weight of China A-shares will increase over time as the mainland China markets become more open to foreign investors, according to Chris Mellor, a product specialist at Invesco PowerShares. He notes that the first stage of inclusion in May 2018 will have a 2.5% partial inclusion factor (the percent of the free float market cap that is used to calculate the weight of China-A shares in the EM index). A second stage in August will increase the inclusion factor to 5%. Although the near-term flow effect is limited, the impact on A-shares and China’s capital account and currency could be important, according to Sandra Crowl, a member of the investment committee at Carmignac. “As access to the Chinese markets increase, so will the eligibility for a bigger allocation,” she says. “At 100% inclusion factor the weight of Chinese A-shares could reach 14.6% on the overall MSCI EM index.” Angelo Corbetta, head of Asia equity at Amundi, also believes the MSCI inclusion is the beginning of a much larger process of China opening its borders to capital flows and lowering hurdles for foreigners making investments in the country as well as gradually lowering domestic protectionism and increasing competition in capital markets and markets in general.

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