China's prospects as a potential superpower are frequently debated.
China’s one of the world’s fastest-growing market. As its economy has grown, so has the number of Chinese companies.
This extraordinary performance was made possible by the economic reforms initiated by the authorities, which gradually adopted free-market mechanism so the opportunities for investors have expanded at a phenomenal rate.
In the past, it's been difficult for most overseas investors to get exposure to China because of its rules on foreign investment. Every investment project requires specific government approval, with restrictions and regulations varying across industries and regions and subject to regular change. But things are changing.
The Chinese bond and equity markets are perhaps the third and second largest in the world, but international participation remains low at just over 2% of domestic bonds and nearly 7% of Type A-shares.
China’s efforts to open up its capital markets to a broader set of foreign investors are expected to lead to greater domestic market volatility and more money flowing in and out of the country.
In this article, we will try to analyze the barriers of investment in Chinese financial markets for foreign investors (US and European investors).
China is a market far too big today to be ignored! Investors can even choose to dedicate a specific allocation within their portfolios, in a market where it is not easy to position themselves.
China's long transition to a consumption-based economic model and the likelihood of increasing current account deficits requires greater capital inflows from foreign investors. China has made significant progress in opening up its economy and liberalizing its markets over the past two decades, but it must not stop there.
Despite its size, the Chinese equity market remains largely underrepresented in global indices. About two thirds of the value of shares of Chinese companies are not available for trading, a stark contrast to the US stock market. Restrictions on capital movements and public ownership remain the two main obstacles to freer movement of capital.
Also, increased demand of American and European investors to invest in Chinese stocks whilst dealing with a barriers getting information. For example, nobody in America heard of BYD or Tencent but these are huge Chinese company.
Continental companies have no choice but to make different compromises to decide where to legally set up and where to offer their shares. As a result, Chinese companies are currently traded in five different currencies, on no less than seven stock exchanges.
Many of them are forming or introducing their shares on the stock market abroad for various reasons (lower tax rates, favorable regulations, etc.). H shares are strongly represented in the Chinese indices, but they are mainly from the financial sector and are not fully representative of Chinese public markets. The Chinese government remains a major shareholder, and a large part of corporate actions is still not available for trading.
A more consumer-driven market
Chinese equity markets are very different from those of other countries. Individual investors hold most of the continent's listed shares, so portfolio turnover is significantly higher than for longer-term institutional investors. In addition, stocks represent only a small portion of their wealth. Households invest mainly in real estate, wealth management products and bank deposits. The stock market also plays a relatively small role in financing Chinese companies in relation to bank loans and deferred profits. As a result, Chinese companies are less sensitive to market shifts than their counterparts in the developed world.
China's Shanghai Composite Index is dominated by state-owned companies, which for instance represent the ten largest capitalizations. The Communist Party trades only a small portion of the capital of these companies, and retains control of the rest. The share price therefore only partially reflects the valuation of a company. Prices may be more indicative of market and demand liquidity than business value.
Opening to foreign investors
China currently makes up 31% of the MSCI Emerging Markets Index, and most emerging markets funds already have some exposure to the world’s second-largest economy. This allocation is mainly made up of Chinese companies that are listed on overseas markets though, including Hong Kong, while some well-known names, including large tech firms like Alibaba and Tencent, are listed in the US.
The A-share market includes a much broader set of opportunities. There are over 3,500 companies listed on the market compared with 1,200 that are listed overseas.
As part of its initial initiatives to open the local market to foreign institutional investors, China launched quota programs in 2002 (QFII) and in 2011 (RQFII). These programs ultimately allowed asset managers to create international ETFs offering exposure to mainland China securities. Later, in 2014, the authorities launched the Shanghai Hong Kong Stock Connect program, which allows investors to sell and buy Shanghai-listed stocks without the prior approval of the Chinese supervisory authorities through a brokerage account in Hong Kong. The Shenzhen Hong Kong Stock Connect was launched a few years later. Finally, MSCI started to integrate A shares into its Global Standard Indexes in June 2018.
Regarding MSCI, this benchmark index provider for emerging markets has recently announced its intention to quadruple the weighting of the MSCI China A Inclusion Index within its Global Standard Indexes, from 5% to 20%. In addition to adding 253 large-cap Chinese A shares, MSCI will expand its coverage to include 168 mid-cap companies for the first time. The inclusion of 27 ChiNext shares is another sign of future diversification, with the addition of stocks from growth sectors such as IT and healthcare.
China under pressure to diversify
Despite having to battle a trade war with the United States, China remains under pressure to open up its financial markets. China has softened and lifted restrictions on foreign investment in new sectors. The growth in the financial services sector will contribute a lot of growth in the coming years.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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