Why offshore investors are careful about China

The decision by index provider MSCI to delay the inclusion of A-shares into its emerging-market indices on June 15 disappointed China’s market regulator, local fund managers and state media alike.

The China Securities Regulatory Commission (CSRC) said any global stock index without A-shares is incomplete, so international investors should not wait for a perfect moment to include the market into their investments. Xinhua news, the state media agency, said it felt sorry for MSCI’s “lack of foresight”, and opined that an index inclusion was better sooner than later.

The language used by these critics was telling. From their perspective, the opportunity offered by China trumped any regulatory uncertainty. MSCI felt the opposite, which is a sizeable problem.

Denying China again wasn’t an easy call for MSCI, whose indices are followed by 95% of global institutional investors. “MSCI has been under a lot of pressure from the Chinese regulator for the country’s inclusion; their dialogue has been ongoing for quite a long time,” said one source familiar with the dialogue.

But there are plenty who back the index provider's stance. “Certainty – clear rules and straightforward implementation – are what asset managers and institutional investors want,” said Eugenie Shen, head of the asset management group at the Asia Securities Industry & Financial Markets Association (Asifma).

Even some advocates of inclusion were supportive. “This was a brave stance by the MSCI executives,” said Mark Mobius, executive chairman of Franklin Templeton’s emerging markets group, who supported inclusion this year. The indices’ credibility will be maintained with such high standards, he added.

The CSRC needs to make clear how it polices the market, before foreign players will be comfortable investing in China, said Nicholas Yeo, Hong Kong-based head of China and Hong Kong equities at Aberdeen Asset Management. He hopes the raft of regulatory interventions that took place in the stock market in 2015 and at the start of this year will not be repeated again.

US hesitation

“Sentiment towards China remains sceptical, almost pessimistic. This reflects a lack of exposure,” said Jan Dehn, head of research at Ashmore in London.

US asset manager Invesco published the results of a survey of 77 sovereign institutions last month, in which respondents said they had reduced allocations to China assets to 1.7% during 2015 from 2.2% in 2014, despite increasing exposure to emerging Asia to 2.3% in 2015 from 1.6% in 2014.

Wang Qi, the CEO of MegaTrust Investment (HK), argued that this lack of confidence, particularly from US pension funds, factored into MSCI’s delay.

American investors have $22 trillion in assets under management, yet most have barely dipped their toes into renminbi-denominated assets. This was partly because the US was not included in China’s renminbi-qualified institutional investor (RQFII) scheme until last month, but it also reflects a lack of confidence in A-share performance.

One example is the Tallahassee-based Florida State Board of Administration (SBA). In October 2014 it mandated Chicago-based external manager William Blair to invest [$100 million] into A-shares as part of its frontier-market exposure. But the $180 billion pension fund, the world’s 16th largest in terms of assets, has since terminated the mandate.

John Kucawanski, a Florida SBA spokesman, told AsianInvestor: “the China A-share market is not liquid like other markets [in terms of repatriating capital], and market intervention is high, as we saw last year with the halting of many stocks.”

The pension fund has no plans for any dedicated A-share exposures in the near future, he added.

Credit considerations

The situation for bond investors is less straightforward.

China removed quota controls and capital repatriation constraints on its $6.7 trillion interbank bond market in February. The opening is part of a broader plan to underpin the inclusion of renminbi in the International Monetary Fund’s $285 billion special drawing rights (SDR) basket in October.

Several offshore bond investors have described the unlocking of the world’s third-largest bond market to foreign investment as a once-in-a-generation development. It offers a huge market with better liquidity and more duration choices than existing offshore renminbi- or dollar-denominated credit from Chinese issuers.

Moreover, 10-year Chinese government bonds offer a yield of nearly 3%, while US Treasuries are yielding around 1.5% and Japanese bonds and German bunds are trading in negative territory. 

“Lower risk and higher return makes a compelling case for adding, especially if you start from zero,” said Ashmore’s Dehn. Chinese government bonds offer better value than those in developed markets, with their asset-reflation policies, he added.

“The China government bond market offers positive real rates across the government bond curve.” noted Robert Simpson, a portfolio manager at UK-based Insight Investment, the first overseas firm to register under the CIBM programme, last month.

However, many foreign investors are waiting for clarity on tax treatment and the ability to hedge onshore exposure, said Asifma’s Shen. The main problem is that they don’t know whether they need to pay 10% capital gains tax under the new interbank investing programme. 

Added to this, the country’s immature credit rating system gives international investors pause.

“The onshore credit rating mechanism is distorted with little differentiation in credits and risks; a single B name in the international market is able to get an AA- rating in China,” said Yerlan Syzdykov, head of emerging debt at Pioneer Investments in London. “It benefits issuers rather than investors.”

Until the country clarifies the approach of its rating agencies according to international standards, this could well prove a sticking point.

Another one could be – yet again – index inclusion. The JP Morgan Government Bond Index-Emerging Markets (GBI-EM) has started reviewing a potential inclusion of onshore government bonds. The good news, at least for China, is that most bond managers expect this to happen earlier than an inclusion in MSCI's EM benchmarks.

Until these index inclusion issues are clarified, China looks set to remain a side investment for most global institutional asset funds. The country may gain more traction among investors eager to gain some yield, but its full potential looks a long way from being realised.