MSCI moves Chinese shares further into the mainstream

It wasn't a total surprise – much of it was already coming anyway. But the gusto with which the MSCI news was received on Friday, with the Shanghai Composite Index closing with its strongest weekly gain in four years, hinted at a possible coming of age for China's A-shares market.

It certainly felt like a milestone being passed marking China's growing integration with the global financial system after MSCI said it would more-than-quadruple China’s weighting in that doyen of emerging market benchmarks, the MSCI Emerging Markets index.

And all by November this year. 

But all that has changed is that MSCI now intends to stagger the inclusion of large-cap A shares over three stages rather than two, bring forward the inclusion of mid-cap A shares by six months, and include some of the larger tech names on the Shenzhen stock exchange.

The plan, announced early Friday, will incrementally lift the weighting of China A shares in the MSCI Emerging Markets Index to 3.3% from 0.72% eight months from now. It is expected to include 253 large cap and 168 mid cap China A shares, plus 27 ChiNext shares on a pro forma basis.

For the large-cap A shares, the increase in the inclusion factor will be done in three tranches of five percentage points in May, August and November until it reaches 20%.

ChiNext large-cap shares will be added with a 10% inclusion factor in May, and then in November all eligible A-shares will be increased to a 20% inclusion factor (covering both large-cap and mid-cap shares).

Chia Chin-Ping, MSCI's head of research for Asia Pacific, said in a press conference that the inclusion could bring in around $80 billion of capital inflows from overseas investors.

Remy Briand, chairman of the MSCI index policy committee, added that increasing the weight of China would also increase the risks, so having adequate hedging instruments would become more important. 

In its three-year strategic plan published only a day earlier, Hong Kong Exchanges and Clearing said it planned to launch A-share futures contracts but did not indicate when.

Briand also noted other hurdles to further inclusion such as the short settlement cycle of China A shares, the trading holidays of Stock Connect and the availability of an Omnibus trading mechanism.

CHANGE OF PLAN

The move by MSCI to spread out the inclusion of the large-cap A shares was due to "potential execution pressure on the implementation dates."

Chia said that, during the consultation process, investors felt that doubling the inclusion factor in two phases, as in the original plan, would be challenging as the amount of trading activity and the potential capital inflows it would spur could be “pretty sizable”.

China A shares were first introduced last year into the index in two 2.5% phases.

“Spreading the large-cap weighting increase over three tranches will allow for a smoother transition for the SACK countries (Saudi, Argentina, China, Kuwait) and reduce the potential outflows required from other emerging markets given the two-staged inclusion of Saudi Arabia in May and August, as well as the addition of Argentina in May,” David Rabinowitz, UBS's head of Asia-Pacific market structure, said.

In contrast, the inclusion of mid-cap A shares is to be accelerated.

“Investors are comfortable and, secondly, it also leads to a normalisation of the methodology, so it's back to how we construct indices [by including both large-cap and mid-cap shares]," he said. "From the investor's perspective, they prefer that sort of consistency to happen a lot faster rather than wait for another year.” 

OPENING UP

MSCI’s China inclusion update comes at a time when the market is on a tear with the Shanghai Composite index up 20% so far in 2019.

Coupled with the introduction of Stock Connect in late 2014 and the China Securities Regulatory Commission's proposal to merge its Qualified Foreign Institutional Investor and the Renminbi Qualified Foreign Institutional Investor schemes, domestic Chinese equities look set to remain appealing to investors.

Still to come is the inclusion of Chinese bonds in benchmark bond indices, which some say could yet have a bigger impact.

This article was updated to reflect the inclusion factors of A-shares in May and then November.