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MSCI Inclusion May Drive China-A Growth

April 13, 2018 | Global/Emerging Markets


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The inclusion of China A-Shares in the MSCI Emerging Markets Index and MSCI All Country World Index (ACWI) beginning in June 2018 should increase the relevance of China A-shares—which are stocks of Chinese companies traded on the Shanghai Stock Exchange and the Shenzhen Stock Exchange—to global investors.

As the world's second largest economy, China has long been considered an economic powerhouse.

It also has one of the largest, most liquid, and fastest-growing equity markets in the world, with the Shanghai and Shenzhen stock exchanges listing 3,500 companies with an aggregate market capitalization of $7.5 trillion, as shown in the chart below.

That is second only to the New York Stock Exchange and Nasdaq, and multiples larger than other major emerging markets, such as Korea and Taiwan.

The Shanghai and Shenzhen stock exchanges also have an average daily trading volume of nearly $70 billion, the highest in the world, making these exchanges more liquid than even the New York Stock Exchange.

These mainland Chinese equity markets are also growing rapidly. Over the past two years, there have been more than 500 initial public offerings (IPOs) per year on the Shanghai and Shenzhen stock exchanges.

Moreover, we have seen a boom in private-sector growth, with the number of privately listed enterprises nearly quadrupling over the past decade.

Of the 262 global private start-ups valued at $1 billion or more, 34% are Chinese. That is second only to the United States (which has 47%), according to McKinsey Global Institute. The rest of the world totals just 19%.

Foreign investors can now access rapidly growing parts of the Chinese economy that were not previously accessible. But we still believe China A-Shares are under-represented in global equity indices.

China's weight in global benchmarks—and thus its relevance to investors—will increase materially over the next decade.

That is about to change. Initially, when MSCI adds China A-shares to its indices in June 2018, it will use a 5% inclusion factor and include only 222 large-cap companies.

Based on that, China A-Shares should represent about 0.75% of the MSCI Emerging Markets Index and 0.1% of the MSCI ACWI.

As MSCI increases its inclusion rate, and includes 450 or so mid-cap China A-Shares to the benchmark, China A-Shares could reach nearly 10% of the index. At full inclusion of more than 3,500 companies, China A-Shares could represent more than 15% of the MSCI Emerging Markets Index.

But that is likely far in the future. Reaching full inclusion takes a great deal of time. To provide some historical context about how fast China's weight in global benchmarks could increase, consider Taiwan and South Korea.

Taiwanese equities took nine years (from 1996 to 2005) to achieve full inclusion, and South Korean equities took six (from 1992 to 1998).

China is starting with a much lower inclusion factor of 5% (versus 20% for South Korea and 50% for Taiwan), so I believe it could take at least a decade for full inclusion to be achieved.

It could take at least a decade for full inclusion to be achieved.

The pace of inclusion typically takes into account the limitations that could arise in the opening of equity markets to foreign investors.

In the case of China A-Shares, significant changes have also been made to the Qualified Foreign Institutional Investor (QFII) program—one of the old ways foreign investors can access China A-Shares—and I believe MSCI wants to see those changes implemented properly before increasing its inclusion level.

A few key developments we will look for include the streamlining of the approval process for quotas, the development of the repatriation limit for the QFII program (QFIIs currently cannot repatriate more than 20% of the previous year end's total assets each month), and the effectiveness of trading suspension limits implemented in May 2016.

Casey Preyss, CFA, partner, is a portfolio manager on William Blair's Global Equity team.