Getting greater acces to Chinese 'A-shares'

Charles Sunnucks, assistant fund manager on Jupiter's Global Emerging Markets team, talks about the move to bring China A-shares into MSCI indices and implications for emerging market funds.

Chinese 'A-shares' - the long march to inclusion

This week MSCI announced that Chinese domestic equity A-shares would be included in their indices. This is a significant move for a huge market, which until recently had largely operated under the radar of most foreign investors, and another positive move in the right direction for capital market reform in China.

Improving investability

While investors have been able to access Chinese companies via overseas listings (namely Hong Kong) since the early 90s, the domestic A-share market has been largely overlooked due to investability issues.

Giving foreigners gradually greater access to the local A-share market has been a 15-year long process, which started in 2002 when China allowed a select number of institutional investors to invest directly into A-shares via the "qualification institutional investor" (QFII) programme.

Accessibility has since evolved, and most flows into the A-share equity market are now done via the "stock connect", a bilateral loop linking the Hong Kong exchange with Shanghai and Shenzhen.

The rise of the Rmb

For policy makers, greater foreign participation in Renminbi (Rmb)-denominated investments - in this case, due to index inclusion - is part of a far grander ambition to make the Rmb a truly global currency.

In aiming to achieve this, policy makers have been very methodical in the way that they have gradually liberalised domestic interest rates, and steadily corrected capital market imbalances, to pave the way for a managed relaxation of capital account controls.

Ultimately, as the breadth and depth of accessible investable Rmb products like A-shares grow, so too should the power of the Rmb rise.

Room for improvement

While by August 2018 A-shares will be 0.73% of the MSCI emerging market index, this is a limited amount for a market which accounts for 21% of world turnover and 10% of world market cap.

There is, therefore, plenty of scope for much greater inclusion going forward, although greater change would likely have to be accompanied by further market reforms by the Chinese regulator.

Eventually, given the Chinese listed market cap is now second in size only to the US, and higher than the UK and Germany put together, what may happen is that China - much like Japan now - becomes far more dominated by country-specific funds.

Good for stocks, but a need to be very selective

Historically, index inclusion announcements have supported a rally in stock prices as active managers buy shares in anticipation that more passive flows will follow. The most recent example of this was Pakistan, which, upon the announcement that it would be included the following year, rallied nearly 30% over the following six months.

In the case of A-shares the impact on the broad market is likely to be less, because of the limited weighting relative to market liquidity and size. At a stock level, however, there is likely to be a number of significant movements, as there is a meaningful difference in the types of investments foreign and local investors find attractive.

Chinese investors are dominated by retail money from private investors, and typically chase after smaller firms with enough volatility to potentially make big gains quickly. International investors meanwhile, tend to have a far greater preference for larger cap businesses. The result of this disparity is that while smaller cap A-share companies are often excessively expensive, there are a number of very compelling larger cap opportunities, well positioned to do well from greater foreign flows.

Ultimately, MSCI's decision is another positive move in the right direction for capital market reform for China. Greater institutional ownership of the domestic market should support lower return volatility and, at the company level, put pressure on corporate governance to improve.

In our view, future capital market reform in China will continue to create both significant risks and significant opportunities for Chinese corporates, creating an increasing divergence between those businesses challenged by change and those able to benefit.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.