A rapid pickup in Chinese capital market reforms is prompting benchmark index providers to begin considering what could be the most consequential shift ever in emerging markets index country allocations.
In its annual market classification review, released June 11, MSCI Inc. announced “the start of the review of China's A shares for potential inclusion in the MSCI Emerging Markets index,” citing the pace of market opening measures adopted by Chinese regulators in the past 12 months.
Likewise, in a recent interview, Jessie Pak, the FTSE Group's managing director, Asia, said her firm's research department is completing a detailed paper regarding the outlook for the inclusion of China's A shares in FTSE's emerging markets equity indexes.
A shares are equities listed on local stock markets in China, including Shanghai and Shenzhen. H shares, by contrast, are those of China-domiciled firms listed in Hong Kong.
After a sleepy first decade for the qualified foreign institutional investor program launched by China in 2002 to offer foreign investors a toehold in its markets, the past year has seen a more dramatic opening.
Recent moves have included sharp reductions in the time needed to obtain QFII quotas, less onerous requirements for money management firms and the lifting of the QFII program ceiling to $80 billion from $30 billion, said Chia Chin Ping, Hong Kong-based managing director of Asia-Pacific research for MSCI.
Hurdles remain, among them continued restrictions on foreign investors' ability to buy A shares and repatriate their funds freely, as well as a lack of clarity on capital gains taxes. Executives at MSCI and FTSE concede it could take years before the resolution of those issues paves the way for a full A-shares weighting in their indexes.
Even so, the pace of reform has reached a point where investors have to begin preparing for the “the biggest capital markets opening we're going to see in our lifetime,” said Mr. Chia in a recent interview.
Chinese H shares already are the biggest component of MSCI's and FTSE's emerging markets indexes, with a more than 18% share of each. MSCI's Emerging Markets index now covers 21 markets, while FTSE's covers 22 markets.
Adding China's A-shares market, with its market capitalization of more than US$500 billion, would lift that weighting to roughly 30% of the MSCI index, Mr. Chia said. And that's just the current “opportunity set,” he said. A steady stream of new listings could add further to that market's dominance in coming years, he noted.
FTSE's Ms. Pak, citing a senior Chinese regulator's recent suggestion that the country's QFII target could be expanded by a factor of 10, said such a move would lift China's total weighting in FTSE's Emerging Markets index to 28.9%.
Even with a growing chorus of institutional investors and portfolio managers professing less and less concern about tracking benchmark indexes, the ripple effects of adding China's A-shares market to emerging markets and global equity indexes could be considerable.
In an e-mailed response to questions, Mr. Chia said more than US$1.4 trillion of investor assets is benchmarked against the MSCI EMI, with roughly one-third of that in passively managed strategies. Ms. Pak declined to break out specific numbers for FTSE's index.
There have been previous sharp changes in country weightings. For example, Malaysia, which accounted for 34% of MSCI's 10-country EMI when it was launched at the start of 1988, currently accounts for less than 5%. But the scale of institutional investor money flowing to emerging markets in recent years would add to the potential fallout.
Emerging markets portfolio managers say China's A shares have been on their radar screens for years, with their analysts already covering those companies for investments made via QFII quotas.
In that sense, MSCI's review is “not a surprise, but a reminder that we need to keep on top of” high-quality A-share stocks, and dedicate sufficient coverage to that market from a research perspective, said Nick Beecroft, a Hong Kong-based portfolio specialist with T. Rowe Price Group Inc., serving institutional clients of the firm's US$15 billion global emerging markets strategy.
Many of China's biggest companies are listed both in Hong Kong and locally. But a range of small and midcap companies available only in the A-shares market, in sectors such as consumer stocks or health care, could offer interesting opportunities for additional investments, Mr. Beecroft said.
Even so, some market veterans predict benchmark providers like MSCI and FTSE will have plenty of time to study the A-shares market.
If China were to take the leap to forgo foreign-exchange controls — a precondition to including A shares in major indexes — it would be “a game changer,” but it's hard to see the country's regulators doing so anytime soon, said Mark Mobius, Singapore-based executive chairman, Templeton Emerging Markets Group, in a recent interview.
The day may yet come when China's regulators decide that opening up to foreign investors is the price they have to pay to have a healthy A-shares market, but the likelier prospect is for a very gradual, bit-by-bit process, Mr. Mobius said.
