How might EM investors benefit from the continued opening up of China’s capital markets?
China is the world's second largest economy, with a 16% share of global GDP. But perhaps surprisingly, this position is far from reflected in global stock market indices. China’s share in the MSCI All Country World Index (ACWI) is 3.7%, equivalent to less than double the weight of Apple, the largest constituent of the index.
Since 2008, this gap has increased, as the chart below highlights. This is because the part of the stock market included in the ACWI has not kept up with the rapidly expanding economy. The International Monetary Fund predicts that China’s share of world GDP will further rise to 18% by 2023.
China’s share in the global economy and stock market
Source: World Bank, Refinitiv Datastream. Schroders. GDP data as of 31 December 2018. Index data as of 30 August 2019.
The gap stands out as even more significant when compared to the US, which had a 24% share of global GDP at the end of 2018. It is by some distance the largest constituent of the index with a 56% share as of 30 August 2019.
By this measure, China would appear to be punching below its weight when it comes to the global stock market.
Why is there a discrepancy and is it likely to diminish?
The key reason for this discrepancy is because, for a long time, China A-shares, stocks listed in mainland China and which are the largest part of the Chinese stock universe, were difficult for foreign investors to access due to restrictions on capital flows.
A major shift happened in 2014 with the introduction of the Shanghai-Hong Kong Stock Connect. This mechanism allows qualified foreign investors to trade eligible A-shares without the need for a local Chinese licence. The Shenzhen-Hong Kong Stock Connect followed in 2016. For the first time, investors could access the mainland stock markets without major restrictions.
Index providers have taken notice of this liberalisation. In 2018, MSCI announced that it would add China A-shares to its suite of global indices. Inclusion is taking place on a phased basis: as of September 2019, 15% of the full market capitalisation of eligible large-cap A-shares is included in the indices. The inclusion factor will increase to 20% by the end of November 2019.
After full A-share inclusion, if it ever happens, the weight of China in the MSCI ACWI Index would be around 7%, matching the size of Japan.
What is the status quo for investors?
Currently, the majority of institutional investors invest in Chinese equities through a broad emerging markets benchmark, such as the MSCI Emerging Markets Index. Even though China has a 32% weight in the index, the exposure that index investors actually get is limited.
The MSCI China Index, which is a sub-index of the MSCI Emerging Markets Index, consists of H-shares, Red Chips, P-chips and N-chips. See here for more details on the China’s different stock markets. However, the Chinese stocks included in the MSCI China Index, are only about 16% of the $10 trillion China equity universe.
Prior to 2018, the index completely excluded A-shares, mainland stocks listed in Shanghai or Shenzhen. But the total market capitalisation of A-shares is in excess of $7 trillion, (as of September 2019) making it in total the second largest market in the world, after the US.
The conundrum facing investors
As the weight of A-shares grows, investors will have to decide how to access this part of China’s equity universe, and how much to allocate to mainland equities.
China’s growing importance in the global economy, together with efforts to open up Chinese financial markets to foreign capital, make the decision on the size and composition of an allocation to China equities too important to be left to index providers.
We believe that rather than waiting for index providers to raise the weighting, professional investors should consider a separate satellite A-shares allocation, in addition to a global emerging markets mandate.
Such an allocation would allow investors to access a much larger portion of the A-shares market. The broader opportunity set is necessary to reap the benefits of the compelling characteristics of the A-shares market. This is a market of growing interest to investors of all types.
For individual investors, this is an area they may want to discuss with their financial adviser. It can prompt a conversation to understand what proportion of their portfolio, if any, is already invested in China and/or China A-shares.
If you are unsure of the suitability of any investment, speak to your financial adviser. EM, such as China, generally carry greater political, legal, counterparty and operational risk.
- More of our emerging markets insights are available here, including Head of Greater China Equities Louisa Lo on Where next for China A-shares?
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