By Patrick Ho
China is one of the world’s most dynamic economies and the opportunities for investors to benefit from its growth story are tantalising. While there was a degree of disappointment at MSCI’s decision this week to delay the inclusion of China A-shares in its emerging markets index, investors are keeping their eye on the bigger picture.
There has been little market volatility since the announcement and the long-term impact of the latest delay is likely to be minimal. This is because momentum is on China’s side; it’s a matter of ‘when’ China A-shares are included and not ‘if’.
As a long-term investor in China (we’ve been there since 1997), it’s exciting to think of a time when even more investors will be able to access a raft of exciting investment opportunities when China A-shares are eventually included in MSCI’s indices.
It was positive to see MSCI recognise the ongoing reform efforts in China and the progress that has already been made to make China A-shares more accessible for global investors. MSCI noted the “clear commitment” of the Chinese authorities.
The improvements that have been made during the last 12 months include the resolution of issues regarding beneficial ownership; enhanced regulations on trading suspension, one of the most critical issues for investors; and QFII policy changes aimed at addressing quota allocation and capital mobility restrictions.
Importantly, MSCI’s announcement has provided clarity on the key areas requiring further improvements in order to achieve China A-share inclusion: the abolishment of China’s quota system, liberalisation of capital mobility restrictions, and alignment of international accessibility standards.
MSCI noted the 20% monthly repatriation limit of prior-year net asset value remains a significant hurdle for investors that may be faced with redemptions such as mutual funds and must be satisfactorily addressed.
Investors stand to benefit in a number of ways from inclusion. Indeed, they are already benefiting from the progress towards it. The moves undertaken by China to improve accessibility have also made the China A-share market more efficient. These efforts have already contributed to the positive development of the market, making it more attractive to international investors, and will continue to do so.
Inclusion also represents a hugely symbolic step for the China A-share market. The weighting will be minimal to start; figures that have been suggested include 5 per cent of the China index, which equites to a 1.1% weighting in the emerging markets index.
Even a small initial partial inclusion will attract greater flows to the China A-share market, particularly from institutional investors. These investors are also more likely to invest for the long term compared to the local retail investors that make up the bulk of China A-shareholders.
There are many benefits of long-term investing, of course, but an important one in the China context concerns volatility. Retail investors are notoriously focused on the short term and, given their weighting in the China A-share market, this contributes to some of the market’s volatility. Diluting the retail shareholding will hopefully have the added bonus of making it a less volatile place to invest, and that can only be beneficial for foreign investment into China both retail and institutional.
When a 100% inclusion factor is applied, China A-shares would represent approximately 18.2% of the emerging market index, according to MSCI, making it the largest constituent within the index. But it will be a gradual process. For instance, it took six years for Korea to go from 20% to full inclusion and nine years for Taiwan to go from 50% to full inclusion.
Ultimately, MSCI has stated that the future pace at which China’s partial inclusion factor is raised will depend solely on the development and further reform of the Chinese market. Given the speed at which China develops and the commitment towards addressing the remaining accessibility issues, China’s growth path may be faster than other countries.
China A-shares will remain on MSCI’s 2017 review list for partial inclusion but it may happen sooner than June next year. MSCI has flagged it may bring forward a decision before the scheduled timeframe if significant positive developments occur ahead of time.
Patrick Ho is head of Asian equities at AMP Capital
