MSCI Market Reclassification: What’s Next for China?
Author: Angela Rhoden
June 22, 2017
In a milestone event for China’s capital markets, MSCI announced on June 20th that it will add 222 mainland Chinese stocks to the MSCI Emerging Markets Index (EM). The rebalancing will occur in two stages, starting in May 2018 (inclusion factor: 2.5%) and again in August 2018 (inclusion factor: 5%) with A-shares expected to account for approximately 0.7% of the MSCI EM by August 2018.
The initial market reaction was positive with Shanghai Composite and the Shenzhen Composite (A-shares) closing 0.5% and 1.2% higher, respectively, on the day of the announcement. However, the Hang-Seng Index (H-shares), currently the only China index included in MSCI China, closed 0.6% lower. Other Asian markets also moved modestly lower following the announcement with the Nikkei down 0.5%, the Kospi Index down 0.5% and the ASX 200 Index down 1.6%.
In the short-term, the impact to global investors is expected to be fairly muted, given A-shares will account for approximately 0.7% of MSCI EM in 2018. However over the longer-term, this development should not be ignored. Taking from the experience of South Korea and Taiwan, China A-Shares could obtain 100% inclusion within a 5-10-year timeframe, and therefore grow from 0.7% of MSCI EM in 2018 to as high as 17-18%. This would take China’s weight in the overall EM index to close to 40%.
Source: CIMB, Bloomberg as of June 21, 2017
That said, it will be incumbent upon China to improve accessibility to the A-share market to international market accessibility standards in order to gain full inclusion. There are three preconditions that must be met: 1) significantly increase the daily quota limitation for Stock Connect from the current $4 billion; 2) lower the number of stocks with trading suspensions from the current 7%; 3) implement corporate governance reforms.
AGF Investments’ View
In our view, the decision to include China A-Shares in the MSCI Index is not surprising, given the recent support of some of the world’s largest asset managers. It does reflect the fact that China is too big to ignore for global investors, as the 2nd largest equity market and 3rd largest bond market. China could arguably be an asset class of its own, similar to the U.S. within the developed market context.
More importantly, inclusion of China A-Shares expands opportunities for global investors to invest in a vibrant domestic consumer and services in China. The A-Share market has greater exposure to the Consumer Staples, Financials and Industrials sectors relative to MSCI China (depicted above) and therefore expands the opportunities available in these sectors. It is also worth highlighting the higher cyclicality of the A-share market with 65% exposure to the top cyclical sectors (Financials, Energy, Industrials and Consumer Discretionary) compared to 45% exposure for MSCI China.
Finally, we expect that opening up the China A-share market will lead to higher capital inflows from international investors and in turn drive corporate reform. This is because, as the 2016 IMF Global Financial Stability Report highlights, the involvement of international investors typically leads to improvements in corporate governance.
The decision by MSCI to add China A-shares is a positive development for investors, although it will take time for China A-shares to be fully included in the MSCI Emerging Markets Index. We believe that over time, China is likely to become a significant market within the Emerging Markets context provided it is able to enact the necessary reforms.
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