Market commentary | Emerging markets 5 things to expect from MSCI A-share inclusion

Overseas investors will become more active in A- shares as they are included in MSCI Emerging Markets Index. What else can investors expect?

23 May 2018

Overseas investors to become more active in A-share markets

MSCI inclusion makes Chinese equities mandatory for investors tracking MSCI's Emerging Markets benchmark.  As such, overseas investors will become more active in the A-share market.

This is already happening. Overseas investors' holdings of Chinese equities have grown, aided by direct access from the Shanghai and Shenzhen Stock Connect programs.

As reforms continue and overseas investors get more familiar with the structural changes and opportunities available in China, we expect more foreign capital to find its way into the A-share space.

Overseas investors holdings up by more than 140% in over 2 years

Improved standards and opportunities for fundamental strategies

As overseas investors become more active in the market, so listed companies in China will be under tougher scrutiny and they'll have to bring their disclosure and governance practices into line with international standards.

That's good news for investors and the market as a whole.

Improved disclosure enables closer analysis of companies and gives fundamental investors better insight into corporate quality.

That's valuable in China. Retail investors are dominant in the A-share market and their trading behavior can create market pricing inefficiencies and volatility, which fundamental investors focused on corporate quality can exploit.

Aside from trading opportunities, greater participation by overseas investors, like institutional investors with long-term oriented outlooks, has the potential to reduce the influence of the retail investor base and create a less volatile marketplace, which is positive for the long-term development of China's capital markets.

MSCI A-share inclusion process will continue

But MSCI's move to include A-shares is one step in a journey that we believe will see Chinese equities brought more fully into global indices.

That's because recent policy statements show China's government is committed to opening onshore markets to improve their efficiency and structure. Furthermore, MSCI has indicated it will move to include more A-share stocks in the future as China reforms1.

However, the process from partial to full inclusion is a long one, so changes won't happen overnight. For perspective, it took Korea and Taiwan six and nine years, respectively, to go from initial to final inclusion.

Real impact of MSCI inclusion is long-term

All of the above factors will bring changes that we believe will improve the structure and fundamentals of A-share markets over the long term.

But we feel it's important to focus on these factors rather than to expect a noticeable short-term boost to A-share markets from index inclusion.

That's because, firstly, the estimated capital flow triggered by index inclusion of USD 18.4 bn2 to USD 19.4 bn3 is too small to move the A-share market, which has an estimated free-float capitalization of USD 3.4 trillion.

Secondly, investors who closely follow the MSCI Emerging Markets benchmark have probably already adjusted their portfolios since it's been a year since index inclusion was announced in June 2017.

Thirdly, many overseas investors remain unfamiliar with China's equity markets. That means instead of rushing to put capital to work, overseas investors will likely remain cautious about A-shares and look to gradually allocate to the market over time.

Company quality remains paramount

While we're positive on index inclusion, it's important to remember that company quality drives performance over the long-term, not whether a company is included in a benchmark.

Because of this, long-term investors in China are better served by looking closely at how competitive A-share listed companies are, rather than paying attention to whether they fall into the MSCI EM benchmark.

We believe that as reforms progress, the impact of integration with global financial markets continues, and the quality of Chinese companies improve, there remain many opportunities that make the A-share space an attractive market for many years to come.

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