How China's inclusion in the MSCI emerging market index will impact investors

 
Darius McDermott
TOPSHOT-CHINA-ECONOMY
Asian superpower to be included in MSCI index next year (Source: Getty)

It has taken more than three years of discussion but the creator of the global stock market indices, Morgan Stanley Capital International (MSCI), has decided to let 222 of China’s larger domestic A-share stocks be gradually included into the emerging market index from June 2018.

The Chinese A-share market is made up of companies that are based in mainland China, quoted in renminbi, and listed on either the Shanghai or Shenzhen stock exchange.

Formed in 1992, the A-share market is still relatively young and is dominated by millions of inexperienced retail investors. This means rumour and speculation have a huge influence on their behaviour, and flows in and out can change very quickly, making it a volatile market.

This volatility was evidenced at the start of 2016 when, having shot up around 80 per cent in six short months, the A-share market plummeted more than 40 per cent amid fears of a devaluing currency, high company debt levels, and slowing economic growth.

Trading was suspended twice in the first week of the year by an automatic circuit breaker put in place to avoid investor panic. The MSCI has been naturally cautious and deferred inclusion on more than one occasion.

What is all the fuss about?

The 222 companies to be included represent five per cent of the £5.5 trillion Chinese A-share market. This move is seen as an important step in widening access to China’s stock markets and also signifies China’s increasingly important role in the global economy, says Matthew Vaight, manager of the M&G Global Emerging Markets fund.

Matthews Asia, the specialist equity fund management company, agrees saying: “China’s A-share market is simply too big to be overlooked by global investors. It is the second largest equity market in the world, both in terms of market capitalisation and turnover.”

What does it mean for investors?

The immediate impact will be small to non-existent, according to Aberdeen’s head of Chinese and Hong Kong Equities, Nick Yeo, not least because the implementation won’t happen until next summer.

However, when the shares are included, it could lead to around $5-15bn of flows into A-shares from passive funds tracking the MSCI Emerging Markets index, which will be obliged to buy the shares in these companies.

Full China A-shares inclusion could yet be a few years away but when this finally happens, A-shares could account for almost 20 per cent of the index. When added to the existing offshore Chinese share weighting of 27 per cent, it will mean China could represent around 45 per cent of the benchmark.

What are the risks?

Risks in China are plentiful. A-shares are notoriously volatile, as I’ve already mentioned. Add to this the government intervention we have seen in the past, and you have the basis for wild swings in returns.

At a company level, corporate governance is very much a work in progress and there are still concerns about over-capacity, excessive debt in the financial system, and a property bubble.

Goldman Sachs Asset Management also says the stocks to be included into MSCI indices remain tilted towards “Old China” industries.

More foreign and institutional investors entering the market should be positive and help reduce volatility (albeit only a little, as China is still an emerging market).

Their participation should also gradually drive up standards of company accountability.

As M&G’s Matthew Vaight says: “the authorities have improved the functioning of domestic markets in order to meet MSCI requirements; the next step is companies themselves also raising their game.”

Is now a good time to invest?

On the face of it, the market looks attractively valued, but it is being skewed by the banks and real estate companies that are at the centre of China’s bubble worries. Other sectors look expensive. So stock selection will also be key to being successful in this market.

While the risks are many, the breadth, depth and future potential of China’s A-share market is huge.

It is also still relatively under-researched, which means there are many interesting stock-picking opportunities, particularly in the sectors benefiting from the strengthening consumer and rapidly aging population. Some companies have the potential to become global market leaders.

I would be cautious about investing a big lump sum at the moment but smaller monthly amounts may reward over the long term.