After years of “Will they? Won’t they?” back and forth, on June 1, 234 of China’s domestically-listed A-shares will be included in the MSCI Emerging Markets index. The immediate inflows driven by this move will be small, amounting to roughly US$13bn in 2018. Nevertheless, the inclusion of China’s onshore stock markets in the MSCI EM index will put A-shares on the radar screen of many global investors for the first time. It will be worth paying attention. Once dismissed as nothing but a crazily volatile casino, A-shares are rapidly becoming a more interesting and investable market.
At first glance, the addition of onshore Chinese stocks to the MSCI EM index is hardly a game-changer. From next month, the 234 A-shares will be included at 2.5% of their free float, rising to 5% in September. At that point, the A-share market will be weighted at just 0.78% in the index. With assets of US$1.7trn managed against MSCI EM, that implies initial inflows into the A-share market of around US$13bn, or RMB84bn. That’s not to be sniffed at, but it’s small relative to the RMB106bn that has already flowed into China’s onshore equity market so far this year through the “Connect” arrangement with the Hong Kong stock exchange.
Nevertheless, inclusion in the MSCI is a symbolic step, which marks how much China’s domestic stock market has developed over recent years. Among the key steps in the market’s evolution has been a change in the regulations governing IPOs. Until 2016, would-be investors in new issues were required to post collateral against their subscriptions. With IPOs often oversubscribed by 100 times or more, new issues threatened a serious withdrawal of market liquidity. The removal of this requirement in March 2016 has enabled a wave of more than 700 IPOs to come to the market, while the CSI 300 benchmark has climbed 40%.
Crucially, 89% of these new listings are private companies which do not count the state among their major shareholders. And 52% operate in the consumer, healthcare or information technology sectors, compared with 44% before 2016. Moreover, in recent months regulators have been pioneering a fast-track approval process for technology companies like Foxconn and New York-listed WuXi AppTec to list onshore. None of this affects the stocks included in MSCI’s initial A-share tranche. Those have been selected as large caps, accessible through the Connect schemes and with no recent history of suspension. But as MSCI adds mid-caps in future rounds of inclusion, a number of these private sector consumer and new economy plays are likely to be included in the index.
As well as unblocking the IPO pipeline, China’s regulators have moved aggressively to eliminate multiple sources of market instability and reduce hidden leverage. In particular, they have targeted insurance companies, following an embarrassing and protracted takeover battle in which little known insurer Baoneng Group raised billions of renminbi from quasi-debt insurance products to fund an attempted acquisition of China Vanke, at the time the country’s largest property developer.
Another new set of regulations landed in January governing the ability of company founders to pledge their stock holdings as collateral for debt. This is an important move because of founders’ tendency to use the funds raised to buy more of their own stock, so exacerbating volatility both in bull markets and in bear markets, when margin calls led to forced sales.
While these are positive moves, China is very much still an emerging market. Notably, the regulators’ efforts to make structural improvements that reduce market volatility have themselves triggered intermittent bouts of panic, as investors have tried to figure out the implications of sweeping new regulations emerging from an opaque decision-making process. This kind of policy-induced uncertainty is here to stay.
The corollary of this opaque interventionist model is the existence of the National Team—a cabal of state-owned enterprises which can step into the market to provide stability. In 2015, the National Team intervened to the tune of around US$210bn to arrest plummeting stock prices, a position which we estimate has now been sold down by around two-thirds. These are guesses, however, because National Team activity is a national secret. Depending on your personal philosophy, the existence of shadowy state entities intervening to stabilize prices may be a plus or a minus.
Trading suspensions, a second lever employed to control volatility, are an unalloyed minus. Some 6% of stocks are currently suspended, for reasons that in most cases boil down to “We don’t want our stock price to fall”. Even the largest companies are susceptible. China Vanke was suspended for months from late 2015 to early 2016 at the height of its takeover battle. Similarly shares in telecoms equipment giant ZTE have been suspended since mid-April following the imposition of penalties by the US Commerce Department. Still, things are improving. Having 6% of the market suspended is hardly ideal, but a year ago 8% of stocks were suspended, two years ago 10%, and three years ago it was 13%.
The prevalence of suspensions emphasizes that there are still plenty of bad apples in China’s onshore markets. Investors cried foul this year after leading seafood company Zhangzidao Fishery claimed for the second time in four years that it had lost almost RMB1bn of scallops to “adverse ocean conditions”, even though other farms in the neighborhood reported no problems. The profits of many companies, notably in the electric vehicles sector, remain heavily reliant on arbitrary and frequently revised government subsidies. And the whole market remains vulnerable to policy-induced uncertainty.
Despite these risks, investors are already voting with their feet in favor of A-shares. Since MSCI announced last June that it would include A-shares in its EM index, cumulative inflows into the market through the Connect schemes have doubled from RMB222bn to RMB452bn. This enthusiasm is justified. The CSI 300—a good proxy for the stocks MSCI is including—is down -5% so far this year. However, China is in the early stages of an easing cycle , an environment which tends to be strongly positive for equity markets, while construction, industrial activity and profit growth remain robust. As a result there is considerable upside potential for A-shares.