Nicholas Borst
On June 20, MSCI announced the inclusion of Chinese A-shares to its widely followed emerging markets index.1 The decision follows a long series of reversals that have prevented the stocks of the world’s largest emerging market from being included in one of the most important global equity benchmarks. MSCI’s decision to add China, albeit gradually and as a small proportion of the total index, represents a major breakthrough for China’s onshore stock markets.
Investment managers use indices to guide asset allocations, seeking to replicate or outperform the holdings of a particular index. An estimated $1.6 trillion in investment funds track the MSCI Emerging Markets Index. As of June 19, Chinese stocks listed overseas already accounted for 28.8 percent of the total market capitalization of the MSCI Emerging Markets Index. Following MSCI’s June 20 decision, stocks listed in Shanghai and Shenzhen will also become part of the mix.
According the MSCI’s announcement, 222 large cap China A-share stocks will be added to the index. As Figure 1 shows, MSCI will initially use an inclusion factor of 5 percent of market capitalization to determine their weights, which means these Chinese stocks will account for 0.73% of the total index. The stocks will be added in 2018 in two separate steps to account for limitations on capital inflows.
Given the relatively low weighting in the index, the $12 billion or so that will flow into China is unlikely to make a large impact on domestic stock markets, which have nearly $7 trillion in market capitalization and roughly $70 billion in daily turnover. But this move sends message to global investors regarding reforms undertaken by Chinese policymakers and signals further integration of China into the global financial system.
Index inclusion has been a goal of Chinese policymakers for several years now. During three previous Annual Market Classification Reviews, MSCI has declined to add China. China’s controls over foreign capital inflows and outflows have been a significant barrier to inclusion. Although China has created several initiatives to allow foreign investors into Chinese stock markets, such as the Qualified Foreign Institutional Investor (QFII) and Renminbi Qualified Foreign Institutional Investor (RQFII) programs, there are significant restrictions on the free flow of capital. Investors in these programs receive an investment quota and are subject to a lockup period and restrictions on how much capital can be repatriated each month. While these programs have been expanded in recent years and some of the restrictions have been relaxed, many global investors continue to view them as overly constraining.
Another significant roadblock to China’s inclusion occurred in 2015. As shown in Figure 2, following a dramatic run up in prices during the first half of the year, Chinese stocks began to fall precipitously in the summer of 2015. Fearing that turbulence in the stock market could lead to wider financial instability, Chinese regulators took a series of dramatic actions. Short-selling was prohibited, new initial public offerings were halted, large stockholders were prevented from selling shares, and a large number of stocks were temporarily suspended. In addition, state-owned enterprises and government funds were instructed to buy shares to support the market. These actions startled international investors and ultimately set back China’s efforts to be added to global stock indices.
Chinese regulators have gradually unwound most of the extraordinary actions implemented during 2015 and have taken steps to improve market infrastructure and supervision. Perhaps more importantly, China has undertaken two important reforms designed to open up domestic stock markets, the Shanghai and Shenzhen Stock Connect programs. Established in 2014 and 2016, the Shenzhen and Shanghai Stock Connect programs are important new channels for foreign investors to purchase Chinese stocks, free from many of the restrictions of the QFII and RQFII programs. Via the stock connects, foreign investors can purchase a large proportion of the stocks on the Shanghai and Shenzhen exchanges through brokers in Hong Kong. Importantly, all the large cap stocks added to the MSCI index are tradable via the stock connect programs. At the outset, the programs were subject to both a daily quota and overall quota. However, in late 2016, the aggregate quota was scrapped, removing a key barrier to the growth of the foreign inflows. For MSCI’s decision, the stock connects are a “game changer.”
Despite these positive changes, many global investors harbor concerns over the openness and liquidity of Chinese stock markets. As seen by the reactions to MSCI’s announcement, some investors believe China was added too quickly, less than two years after the 2015 stock market turbulence. Many issues remain, including China’s policy on cross-border capital flows, availability of onshore risk hedging instruments, and the effectiveness of investor protections. That China was added despite these concerns is evidence of the intense desire of many investors to increase their exposure to China’s large and fast-growing economy.
An increase in China’s share of the index is not a given and will depend on continued market reforms. The weight of A-shares in the index can grow through both an increase in the inclusion factor, currently only 5 percent, and the addition of new stocks, such as medium-sized enterprises, as they meet MSCI’s trading criteria. If Chinese policymakers can continue the recent positive direction of reform, onshore Chinese stocks could end up accounting for the largest share of the index in line with the global size of China’s equity markets.
1. A-shares are equity securities of China-incorporated companies traded on the Shanghai and Shenzhen stock exchanges (onshore stock exchanges). They are quoted in the Chinese currency, renminbi.
The views expressed here do not necessarily reflect the views of the management of the Federal Reserve Bank of San Francisco or of the Board of Governors of the Federal Reserve System.