In a widely expected move, the MSCI announced a quadrupling of the inclusion factor for China A-shares from 5% to 20% and the changes will be carried out in 3 phases, 5% increment each in May, August and November, an upside surprise vs. the originally proposed timeline of May 2020. Mid-caps and ChinNext will also be added at this 20% inclusion factor and there will be 253 Large and 168 Mid Cap China A shares, including 27 ChiNext shares in the MSCI Emerging Market Index upon completion of the three-step implementation in end-Nov.
Implications of MSCI’s decision:
1. Impacts to China and regional equity fund would be relatively larger than global funds.
China A-shares weight will increase to 10.4%/4.0%/3.3%/0.4% of MSCI China/Asia ex-Japan (AeJ)/ Emerging Market (EM)/All Country World Index (ACWI) by end-Nov 2019 vs. 2.5%/0.9%/0.8%/0.1% currently on a pro-forma basis.
Figure 1. China A-share weight to increase over 4 times in MSCI indexes
Sources: MSCI, FactSet, Noble Apex/iFund
2. China equities are playing an increasingly important role.
In aggregate, onshore and offshore China equities (China A+H+ADRs) would account for around 35%/39% of EM/Aej and 4% of AC World at a 20% of inclusion factor.
3. Northbound fund flows continue to rise and support the market.
Market generally expects the 15% inclusion factor increase could lead to a US60-75bn of northbound net buying to China A in 2019 (vs. $44bn in 2018, $30bn in 2017 and $9bn in 2016), while Passive/Active inflow mix will be around 20/80. It is expected that the net buying inflow to A-share will further increase in 2020.
4. Record high Northbound inflow YTD.
US$18bn in two months via the northbound Stock Connect scheme, which may partly due to the early positioning of foreign funds before MSCI’s decision.
5. Foreign investors’ impacts to A-share market are increasing.
According to PBoC, foreign investors’ equity holdings stood at around RMB1.15 trillion or 2.4%/6.7% of A share total/free-float cap of the onshore equity market by end-2018 (vs. 0.8%/2.3% in November 2015). Foreign investor as a group has already exceeded insurance companies as the largest A-share holder, and are likely to rival domestic mutual funds soon.
6. Large-cap, Liquid, Consumer and selected industrial and Technology names are foreign investors favourite.
Although the pace of northbound inflow fluctuates over time in response to domestic and international changes, northbound investors are consistently attracted to large-cap and more liquid stocks with an average market cap of US$47bn and US$122mn daily turnover, based on the 50 stocks with the highest northbound fund inflow. In particular, around 40% of Northbound holdings resides in consumer durables and F&B sector, while healthcare, technology and some selected industrial names are favourites too as foreign investors value the steadier growth in China’s consumption and healthcare needs than investment and exports, and the long-term benefits of economic rebalancing. It is expected that these sectors would benefit disproportionately as the inclusion factor continue to rise.
Figure 2. Northbound investors have overweighed consumer sector
Sources: HKEx, Factset, MSCI, Noble Apex/iFund
7. Some losers in the region in short-term.
The lift of China’s weighting in EM and regional index is at the expense of other countries, which would likely to cause the weighting of Southeast Asian to drop accordingly. Outflow from the Philippines is expected to reach US$700 million per Abacus Securities Crop forecasts, while Citi estimates that India could see outflows of up to US$5bn due to A-share inclusion impact by 2025.
8. Further rise of the inclusion factor of China A-share over the next 5 years.
It could become a catalyst for A-share market re-rating. However, the weight increases beyond 20% would require Chinese authorities to address a number of remaining market accessibility questions, including permitting the listing of index future and other derivatives on onshore and offshore exchanges as well as making improvement in the settlement cycle, trading holidays and omnibus account structures.
9. At full 100% inclusion.
China A shares would account of more than 16% of the MSCI Emerging Markets Index and more than 20% of the Russell Emerging Market Index. Overall, China equities altogether will account for over 40% and 50% of the two indices.
To sum up, MSCI’s decision to raise the A-share inclusion factor represents a very important step for the opening of China to international investment. Increasing foreign investors’ participation should help reduce market volatility and improve pricing discovery in the A-share market as foreign investors generally take a longer-term and more fundamentals-based approach to investing than the more sentiment-driven China domestic retail investors. Besides, it would a good incentive for local companies to improve the corporate governance as well as the transparency to align with the shareholders’ interest.