China A-Shares Going Global: How Will It Affect Asset Allocation?

Includes: FXI, PGJ
by: CFA Institute Contributors

by Samuel Lum, CFA

The long-awaited official statement finally came. After media reports over the past few months about China A-shares being considered as a constituent in the global equity benchmark indices, MSCI announced in mid-June that it is starting "the review of China A‐shares for a potential inclusion in the MSCI Emerging Markets Index, driven primarily by a series of positive market opening measures and strong regulatory momentum over the past 12 months."

Earlier, Mark Makepeace, CEO and founder of FTSE Group, was in Asia to kick off the process of preparing for China A-shares to join the FTSE global equity indices. He hosted a private roundtable of industry practitioners and government officials in Hong Kong, among various other related activities in the region. FTSE customarily undertakes its annual index review in September, and a formal announcement relating to A-shares will likely be made at that time.

Why is it important for asset owners with global equity portfolios to follow this development closely?

The size of China's stock market has grown to be one of the largest in the world, as its economy has also developed to become the second largest, ranking just after the United States. Because of foreign exchange controls, restrictions on foreign ownership, and other factors, the China A-shares listed in the Shanghai and Shenzhen exchanges (with market capitalization totaling around US$4 trillion) are not at this time eligible to be included in the global equity market indices from MSCI, FTSE, and other providers.

After the Communist Party of China came to power in 1949, the centrally planned economy in China had little room for capital markets. Starting around 1982, the "reform and opening up" (改革开放) movement led to a series of reforms and liberalizations, and a market-style economy flourished. The Shanghai Stock Exchange (SHCOMP) was reestablished in 1990, and in 2003, the domestic equity market started opening up to qualified foreign institutional investors licensed via the Qualified Foreign Institutional Investor (QFII) program, but progress has been very slow. Until early 2012, only US$30 billion (which is less than 1% of the total market capitalization) was approved, with $25 billion actually used.

Financial Sector Reforms Accelerating

With China's political leadership transition surrounding the 18th Party Congress in November 2012, there are clear signs that the pace of financial sector reform is being stepped up. Restrictions on foreigners investing in the domestic capital markets are being further liberalized, with new announcements relating to the QFII and Renminbi QFII (RQFII) schemes, including a proposed 10-fold increase in the QFII quota and a commensurate increase for the RQFII scheme. In April 2012, the China Securities Regulatory Commission (CSRC) announced that the quota limit was being raised from US$30 billion to US$80 billion, and since then, the number of QFIIs has jumped from 157 to around 230. In 2012, almost $16 billion of QFII quota was approved, a quantum leap from the prior years' levels, which ranged from $0.9 billion to $3.4 billion (see chart).

QFII Quota Approved (USD Million)

Source: State Administration of Foreign Exchange (SAFE), China. Figures are net of reductions.

There is a general expectation that in the third plenary session of the 18th Central Committee of the party, to be held near the end of this year, specifics of major reform initiatives within a concrete reform agenda will be unveiled.

Impact of Global Index Entry

Liquidity flow into the A-shares market will be substantial as a result of global index entry. According to Lin Lijun, CEO of China Universal Asset Management, a fund house headquartered in Shanghai, their research indicates that an inflow forecast of more than RMB1 trillion (or around US$160 billion) to the A-shares market is quite reasonable and probably on the conservative side.

This is in line with the US$180 billion estimate from Deutsche Bank's China strategists, who are "optimistic that over the next two to three years, the China A-shares will be included (at least partially) in one or more major global benchmarks." Furthermore, they indicated that the A-shares market has ample room to grow given its relatively low market-capitalization-to-GDP ratio. As the market grows, liquidity and stability will improve. In the view of the Deutsche Bank strategists, it could potentially attract US$500 billion to US$1.5 trillion of inflows in the medium to long term, as more investors are attracted to the market.

The Taiwan and South Korea situations in the 1990s provide precedents for how China A-shares might get included in the emerging market indices and other global market indices. However, the size of the China A-shares market is much larger. As in the Taiwan and South Korea cases, the A-shares weight will likely be increased in several steps; and as MSCI and FTSE have indicated, the pace of inclusion will depend on the pace of opening up the A-shares market and the capital account.

Nevertheless, the size of the liquidity inflows resulting from the increases in weighting is presenting unprecedented challenges for the index providers and for the asset owners and managers who benchmark their portfolios against the indices.

Investors outside of China generally have zero weighting in or only a very small amount of China A-shares in their portfolio asset allocation because of foreign ownership restrictions. Now, with the market opening up and potential inclusion of A-shares into such benchmark global indices as those from MSCI and FTSE, many are planning to transition their portfolio asset allocation to incorporate a significant A-shares component and are getting the trading and operational infrastructures in place.

The Issues for International Investors

There are a number of issues that international investors would likely examine ahead of further market liberalization and global benchmark index inclusion. For example:

  • Should the portfolio asset mix follow the weighting of a popular benchmark index, which is market capitalization weighted and thus has relatively high weighting for China A-shares because of the size of the market? Or should the asset mix reflect a lower weighting because of concerns about the A-shares market?
  • Does the investor have enough QFII or RQFII quota to implement the desired asset allocation? And if not, would it be desirable to implement synthetic exposure to A-shares or pursue other solutions?
  • The normal protocol for MSCI and FTSE is to provide a long period (possibly as much as one year) between the announcement of the inclusion of a new market into their global indices and the actual inclusion. A question the investor needs to consider is whether to strategically or tactically front run the index in implementing the A-shares exposure or to lag the index.

And for the index providers, depending on the needs of the investors, additional product and service offerings may be called for. For example, variants of the global indices (such as an "ex-China" version that excludes China A-shares for use after inclusion or a "with-China" version that includes China A-shares for use prior to the inclusion) may need to be offered around the transition period and beyond.

The resolution of these issues to a large extent depends on an assessment of whether A-shares add value to a global equity investment program by enhancing long-term risk-adjusted investment returns, facilitating more effective diversification, or providing other benefits.

Do A-Shares Add Value for the International Investor?

On the one hand, there are several factors that support the thesis that adding A-shares into the asset mix could improve risk-adjusted performance and yield other benefits and favor the incorporation of A-shares into the long-term asset allocation of non-Chinese investors:

  • The China A-shares market historically has relatively low correlation with other major markets, especially those in the United States and Europe. This is an attractive attribute for investors who seek to more effectively diversify their portfolios.
  • Currently, foreign investors can implement "China exposure" only by investing in stocks listed in Hong Kong (H-shares, Red Chips, P Chips), New York (N-shares), London (L-shares), Singapore (S-shares), and Shenzhen (B-shares). There are many companies and sectors that are not in the previous list but only available in the A-shares market. The ability to invest in the A-shares market opens up a broader opportunity set for enhanced return and more effective diversification.
  • There is potential for stable earnings growth as the macro environment has remained relatively favorable compared with other major economies. Longer term, even though GDP growth is expected to decline slightly in line with the central government's policy goal of rebalancing the economy from exports and investment to consumption, it would still be much higher than those of other major economies. According to IMF forecasts, China will be the the largest economy in the world by 2016 on a purchasing power parity basis, though in nominal GDP, it still lags well behind the United States. The OECD more recently also came up with a similar forecast for 2016, and research for the University of Pennsylvania's Penn World Table showed 2011 as the year China's GDP definitively surpassed the U.S.'s GDP in PPP terms.
  • For Chinese companies that are cross-listed in both China (A-shares) and Hong Kong (H-shares), MSCI research shows that A-shares have traded, from time to time, at a significant premium or discount to H-shares for protracted periods (see Exhibit 11 of the report by Chin Ping Chia, head of Asia-Pacific research at MSCI). It is important for foreign investors to be able to take advantage of arbitrage opportunities by building the capability to invest in A-shares. Currently, the premium, as tracked by the Hang Seng China AH Premium Index, has been at a historically low level over the past five-year period.
  • CSRC, the securities market regulator in China, has been putting through measures to improve investor confidence in the markets. These include steps to promote tighter corporate governance, to boost dividend payouts, and to address issues in M&As, IPOs, and other aspects of the A-shares market structure.

Concerns with A-Shares

On the other hand, there are concerns with the China A-shares market. For example:

  • The A-shares market is very much a "policy market" in that government policy generally has very significant influence, and from time to time dominates market and fundamental factors. For example, the real estate development sector was badly hit last year as the government introduced measures to cool the property markets. And more recently, on 24 June, the CSI 300 Index fell 6% after the People's Bank of China (PBOC) issued a hard-line statement the previous day as the interbank lending rate moved to exceptionally high levels a couple of days earlier. The market stabilized the next day, after another statement from the PBOC. However, this "policy sensitivity" applies to all Chinese companies, wherever they are listed, and most developed markets are also subject to policy influence from time to time. To the extent policy moves are in the best interest of the economy or its financial system, long-term investors in many cases are not concerned with the volatility.
  • Corporate governance and audit and financial reporting standards are generally considered to be well behind those in developed markets. Though reform efforts appear to be under way, it has been a topic of considerable debate about how effective these efforts will be and how powerful the resistance of vested interest groups will be relative to the central government's resolve to bring the A-shares market to global best practices and standards.
  • In other major markets, it is well known that there are "asset pricing anomalies" relating to such factors as size, value, gross profitability, and momentum that could be tapped using advanced strategies to produce higher returns in a persistently predictable manner. Does the A-shares market offer similar opportunities? Researchers have found that such anomalies also exist in the China A-shares market. According to Peng Chen, CFA, CEO Asia ex Japan at Dimensional Fund Advisors, the size and diversity of the A-shares market facilitate the implementation of these types of advanced strategies (adapted from what they have used in developed markets to achieve enhanced performance) for the China equity allocation in the asset mix of globally oriented investors.
  • In the near term, there is concern about the overhang of A-shares IPOs. Around 750 deals are in the pipeline waiting to be approved by the CSRC. The regulator has been holding back approval since November 2012, as it is implementing unprecedentedly strict procedures to scrutinize applicants. The CSRC has also significantly elevated due diligence and audit standards for sponsors and auditors, even suggesting the use of unconventional FBI lie-detection techniques. This A-shares IPO resumption risk, however, is considered by analysts to be largely priced in already. Over the longer term, greater investor confidence in financial disclosures and the management of the companies could build the case for higher allocation to A-shares sooner.

On Balance

Balancing the favorable factors and concerns, it appears that international investors would likely seriously consider incorporation of China A-shares in their investment program as the market opens up to foreigners and A-shares join the global equity market indices used by retail and institutional asset owners as benchmarks for their passive or active investment programs.

Much will depend on the pace of liberalization of the QFII and RQFII schemes and foreign exchange controls, streamlining and clarification of tax regulations, and implementation of related market reforms. Under the new political leadership, the prospects for continuing accelerated financial reforms are good. And reports of CSRC officials meeting with MSCI, FTSE, and other index providers, as well as traveling to meet with foreign investors, are encouraging signs that policymakers are serious about hearing from market participants, pushing the needed reforms through, and ushering in a new era for China's A-shares market.

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