25 April 2018
China’s blue-chip stocks have been undervalued because domestic retail investors prefer speculative small-cap stocks. Photo: Xinhua
China’s blue-chip stocks have been undervalued because domestic retail investors prefer speculative small-cap stocks. Photo: Xinhua

How to invest after MSCI again rejects China A shares

China’s domestic shares failed again to make it to the MSCI benchmark indexes this year.

Nevertheless, will the inclusion become a game-changer for A shares?

The MSCI decision did not hurt market sentiment. The initial inclusion of A shares in the indexes with a 1.1 percent weighting will have more of a sentimental impact rather than result in a substantial capital inflow into A shares.

MSCI hinted that it would take a faster approach if China speeds up its market reforms. 

The market is speculating whether or not A shares will get another shot at the indexes in November this year.

Such a move is not without precedent. In November 1997, for example, MSCI included Portuguese stocks into its developed market index.

Some quarters note that A shares account for 90 percent of suspended stocks worldwide. It will take some time to see how Beijing’s enhanced regulations on trading suspension work in the market.

Also, there are two major issues that remain to be resolved. One is the 20 percent monthly repatriation limit under the Qualified Foreign Institutional Investor scheme, which has posed liquidity and redemption issues for fund managers.

In addition, foreign investors are concerned about the existence of anti-competitive clauses restricting the launch of financial products by any financial institution on any stock exchange internationally if these products are linked to indexes that include China’s A shares.

Beijing is unlikely to make any compromise on this matter.

It’s quite ironic that MSCI said the Pakistan stocks index will be reclassified into emerging markets status because Pakistan’s economy is mainly driven by foreign investment.

The Pakistani government has adopted very relaxed rules for foreign investors to access its stock market.

Currently, there are several benchmarks that are relevant to China, including MSCI China, MSCI China A Index, MSCI Golden Dragon Index and MSCI Overseas China. All these indexes do not include A shares.

Nevertheless, MSCI inclusion won’t provide a quick fix to the market.

MSCI earlier said it would maintain the proposed roadmap for a 5 percent partial inclusion of China A shares into the MSCI Emerging Markets Index. And it would achieve the full inclusion of A shares in a progressive way.

That would take about eight to 10 years to complete.

In that sense, the initial 5 percent inclusion will bring capital that is no more than 1 percent of A shares’ market capitalization.

It has very limited impact. It’s believed that the inclusion of A shares will affect MSCI Emerging Market Index, MSCI Asia ex-Japan Index, and MSCI Global Index.

There are roughly US$4.7 trillion of funds tracking those three benchmarks, and therefore a 5 percent inclusion of A shares will bring some US$24.1 billion capital into A shares.

Passive index investors will invest around US$13 billion, equivalent to around 0.16 percent of A shares’ total market value of US$7 trillion.

In practice, the real money that will invest in A shares following their inclusion is only around US$10 billion since domestic exchanges have restrictions on shares held by foreign investors.

By contrast, full inclusion in the MSCI index will bring an incremental capital inflow of over US$400 billion, which represents about 6 percent of China’s overall stock market value.

Also, it will take one more year even if MSCI decides to include A shares in its Emerging Market index.

Passive funds will have to invest more in A shares following the inclusion, but there is no fixed timetable for active funds to build positions.

In that sense, inclusion in the MSCI index is mainly aimed at improving the valuation system for domestic blue-chip stocks rather than bringing massive fresh capital into the market.

Over the last few years, China’s blue-chip stocks have been undervalued since domestic retail investors prefer speculative small-cap stocks.

A-share investors should carefully pick individual stocks rather than buy the whole market, since there is no fresh money flowing into the market in the short term.

This article appeared in the Hong Kong Economic Journal on June 20.

Translation by Julie Zhu

[Chinese version 中文版]

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Senior investment banker

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