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Inevitable Reality? Notwithstanding The Fact That The Inclusion Of China’s A-Shares In The MSCI Emerging Market Index Has Not Been Allowed, It May Not Stay That Way For Long

Of late, there have been a lot of developments in the emerging markets. One such issue that could trigger increasing interest of foreign institutional investors, economists, global funds and others is inclusion of Chinese A-shares in MSCI (Morgan Stanley Capital International) Emerging Market Index.

The decision to not include Chinese A-shares in the MSCI index may have provided respite for investors in the Indian markets. But Chinese A-shares may soon be included in the index.

Let us delve deeper into the implications of inclusion of Chinese A-shares in the index. Also, let us understand this in the form of crucial questions, which could explain the implications of the inclusion of Chinese A-shares in MSCI Emerging Index. This is because understanding these crucial questions can help individuals in knowing how critical it is for the Indian markets. Here is a low-down on China A-shares:

Why Fund Managers Globally Are Concerned About Inclusion Of China A-Share?

A country's classification in MSCI may have a significant impact on the equity markets of that country as it can drive large flows in or out of the country by passive asset managers. Index funds, exchange traded funds, mutual funds, pension funds and sovereign wealth funds that have assets under management, passively tracking an MSCI benchmark, would have to buy constituents of a country that is included in their benchmark or sell constituents of a country that is deleted from their benchmark.

It gained prominence this time around because of the inclusion of the Chinese mainland equities market which is the second biggest market globally with a total value of $9 trillion. Hence, it will command higher weight. This may result in a massive churn in the portfolio of an emerging market fund manager; globally nearly $1.7 trillion funds are benchmarked to the EM index.

How Is A Market Included In The MSCI Index?

MSCI aims to strike a balance between economic development of a country, its equity market size and liquidity, and its market accessibility to global investors. Economic development is mainly related to the developed market. But the remaining two factors are critical for the inclusion in the EM Index. Since MSCI Index is a benchmark for global fund managers, they give more weight to factors such as openness to foreign ownership, ease of capital inflows and outflows, efficiency of operational framework and stability of the framework in a country.

What Are The Hurdles For MSCI To Include China In EM Index?

There are three ways by which global fund managers can invest in Chinese equities: Qualified Foreign Investor (QFI), Renminbi Qualified Foreign Investor (RQFII) and stock connect route. Foreign funds can invest a maximum of $328 billion.

Chinese markets have a cap that ranges from total FII limit in stock, maximum exposure of a fund in a security and daily limit on net buying by FIIs. The clause of limit to buying by FIIs is not there in any other emerging market.

Currently, the daily limit in stock connect route for FIIs is $2 billion per day. So, if net buying in a particular day crosses $2 billion, trading is suspended for the next day. Apart from this, there are issues related to trading settlements, mis-match in holidays between Hong Kong and Shanghai exchanges and lastly, FIIs have access only to 572 securities under the stock connect route.

What Are Other Index Providers Doing To Include China Before Chinese Regulator Eases Trading Restrictions?

Index provider FTSE has introduced two transitional indices, which incorporate China A-shares. It will be merged with standard FTSE EM index once the Chinese regulator eases trading restriction. After the move, Vanguard Group, which oversees $3.3 trillion in assets as the largest US mutual fund firm, said that it will add mainland shares to its $69 billion emerging market index funds.

Experts feel that MSCI may launch a similar product to include China A-shares with a lower free float basis.

How Does The Inclusion Of China A-Shares In MSCI EM Index Impact Indian Equities?

Outflows from Indian equities are also connected to the weight of China A-shares in the emerging market index. Most experts believe that MSCI will start with a 5% free float factor. This means it will initially have 1% weight in EM index. This will reduce weight of India by 0.3%.

India has 7.2% weight in the MSCI EM Index. Passive funds, which have a share of 13% of total Foreign Portfolio Investors (NYSE:FPI), investment in equities would churn their portfolios. Active funds, which have the highest overweight stand on India among the emerging markets basket may change their investment strategy.

If the decision to include China A-shares in MSCI Emerging Market Index finds acceptance, then the weight of the Chinese markets would increase in the MSCI index, which may result in passive funds reducing their exposure to Indian equities and redeploying their funds in Chinese markets. Analysts estimate that in case China A-shares are included in MSCI Index, the weight of China is likely to increase by 13% to 38% in MSCI Emerging Market Index.

If MSCI allows mainland shares for computation of MSCI EM Index, it would lead to potential outflows from the Indian equities. At present, the ownership of foreign funds in the Chinese and Indian markets presents the scope of investments that Chinese markets can attract soon. Foreign Portfolio Investors in the Indian markets own 22% of total equities, while foreign funds own only 5.7% of mainland Chinese equities.

As opposed to Chinese market weight increase, it is estimated that India's weight may come down to 4.5% from 7.2% at present. Out of total $330 billion assets under management of foreign funds in India, 21% is invested by emerging market funds. So, any shift in allocation by these funds would play a pivotal role in the direction of fund flows to India.

Currently, China accounts for about 25% of the MSCI EM Index - which is the benchmark for about $1.7 trillion funds globally - mainly composed of mainland companies listed in Hong Kong - better known as 'H' shares. Inclusion of China 'A' will also impact the way global portfolio managers manage funds equivalent to the size of India's GDP. It is at present pegged at $1.7 trillion funds.

MSCI is expected to include A-shares in a phased manner over the next one year to limit initial impact. As a first step, MSCI will add about 5% of more than 200 eligible A-shares to the emerging-market index, accounting for less than 1% of the benchmark. MSCI will wait for 12 months at least to implement the change to allow investors to adjust their portfolios. The initial inclusion may attract about $2 billion from funds tracking the index, according to MSCI.

Experts reckon that the increase in China weightage in EM index will have a bearing on some outflows of Indian equities. But the extent of outflows would depend upon various factors. The inclusion of China A-shares will obviously result in the reduction in the weight of Indian equities. However, experts point out that the weightage will not be reduced as much as other markets, which will lose out on market capitalization.

Weightage change will have more impact on markets such as the Middle-East or Africa, which have not performed well in the recent past.

About the Author:

Nirmal Bang Securities Pvt. Ltd. is an online share & stock trading company in India. This one of the best trading company where you will see online share trading tips, NSE live news, Indian currency trading market, depository services, equity share market, IPO and live commodity market prices in India for stock and share trading.