As China liberalises its capital markets, big decisions lie ahead for benchmark providers.
[This article previously appeared on our sister site, Europe.ETF.com.]
For index providers and managers of global equity portfolios alike, China is perhaps the biggest deal of the decade.
The recent rapid relaxation of China’s capital restrictions means that the prospect of including the country’s gigantic “A” shares market in global share indices is coming ever closer. But how soon can this occur, and could attempts to benchmark the country’s equity market even bring in new distortions?
Share Class Confusion
Currently China is represented in global equity indices by a bewildering variety of share types, which may be categorised in different ways by different index firms.
According to a recent study by index provider FTSE, only certain categories of freely tradable shares are currently included in its global equity index series: H-shares (Hong Kong-listed companies that are incorporated in mainland China), red chips (Hong Kong-listed shares that are incorporated outside mainland China but which are controlled by Chinese government entities), P chips (Hong Kong-listed companies controlled by Chinese individuals with an establishment and origin in China) and B-shares (foreign currency-denominated shares, listed in Shanghai or Shenzhen, of companies incorporated in the mainland).
By FTSE’s measure, these share class categories recently had an aggregate market capitalisation (after any adjustments for limitations in free float) of $727 billion, or just over 2 percent of FTSE’s Global All-Cap index, a benchmark aimed at capturing nearly all of the world’s investable equities.
But the market footprint of China’s domestic A-shares market is potentially much higher. Although access to “A” shares for investors outside China is currently limited by means of both a quota system and restrictions on foreign ownership, the capitalisation of all 2000-plus A-shares listed in Shenzhen and Shanghai (without adjusting for free float) was recently measured at $3.6 trillion, or a theoretical 12 percent of FTSE’s Global All-Cap index.
A-Share Inclusion Would Have Major Effect
Even if the capitalisation of A-shares were adjusted to remove non-tradeable shareholdings from the calculation, their inclusion in global and regional equity benchmarks would still have a major effect.a
If all restrictions on foreign A-share ownership were removed by the Chinese government, including them in global benchmarks on a free float-adjusted basis would catapult China from its current position of ninth to the fourth largest equity market in the world, after the US, Japan and the UK and ahead of Canada, Australia, Switzerland, France and Germany.
With A-shares included, China would suddenly represent 32 percent of FTSE’s Asia Pacific ex-Japan index (compared to the current 17 percent) and nearly two thirds of the FTSE BRIC index, compared to two fifths currently.
Given that China is the world’s second biggest economy (by GDP) and now the largest trading nation, even fourth place in a league table of global stock markets might not sound like much of an achievement.
Obstacles To Index Inclusion
But getting there is also trickier than it sounds and involves conflicting pressures.
Last summer index firm MSCI announced that it was starting a review of A-shares for potential inclusion in its emerging markets index, saying this decision was motivated by “a series of positive market opening measures and strong regulatory momentum”.
MSCI will announce any decisions resulting from this country classification review in June this year. FTSE’s country classification committee will review China A-shares at its September 2014 meeting. Both index firms say they would require a transition period of at least a year before including A-shares in their indices, meaning that their earliest appearance could be in mid- to late-2015.
Some investors query whether the slow pace of decision-making at index firms is in investors’ interests.
“When people talk about Chinese shares, one of the catalysts for the future performance of the market that people mention is the potential inclusion of A-shares in MSCI’s emerging markets index,” a senior executive at a fund issuer told ETF.com.
“But, with all due respect to the index firms, why as an investor am I waiting for MSCI to decide whether, on technical criteria, A-shares qualify for an index? It’s a bit like the excessive reliance people placed in the past on the ratings agencies.”
Opening Up China Access
Index providers give a cautious welcome to recent Chinese initiatives to liberalise capital controls.
“Foreign access to Chinese A-shares since we made last June’s announcement has become easier, with the further expansion of quota limits and the extension of RQFII status to London and Singapore, although significant restrictions remain,” Chin Ping Chia, head of equity research in Asia Pacific for index firm MSCI, told ETF.com.
The RQFII (Reminbi Qualified Foreign Institutional Investor) scheme, introduced in December 2011, permits foreign investors to buy China’s domestic shares and bonds via funds domiciled outside the mainland. The $40 billion RQFII quota supplements an earlier QFII (Qualified Foreign Institutional Investor) scheme, whose quota limit is a larger $150 billion but which applies more stringent conditions.
In particular, RQFII allows investors daily entry and exit from Chinese assets, whereas QFII requires most investors to wait a month before repatriating cash. Recent London launches of China A-Share ETFs (by Source and Deutsche Bank) have relied on access to RQFII quotas. Both also follow A-share-only indices (from FTSE and CSI).
“If we do include A-shares in our indices in future,” MSCI’s Chin Ping Chia clarified, “it’s highly [unlikely] we would include them in full at once because of quota restrictions and the imbalanced distribution of the quota.”
Asked how any addition future of A-shares to broader equity benchmarks would affect indices’ internal composition, MSCI’s Chin Ping Chia responded that:
“We will follow a ‘one China’ concept and reassess the whole universe of Chinese shares if A-shares join. Currently our methodology allows for multiple share class inclusion and the MSCI China index includes H-shares, B-shares, red chips and P-chips. Sometimes common or preferred shares of the same company do feature in the index.”
In its recent white paper on Chinese A-Shares, index firm FTSE pointed out that many of the existing larger H-shares have associated A-shares, meaning that there is a degree of potential overlap in constituents of a future all-China index.
“Having all these different share classes causes confusion to investors,” Jamie Perrett, director of research at FTSE, told ETF.com.
But some of the share classes may disappear or merge if capital controls ease, Perrett said, pointing to the recent decline in importance of B-shares as an example.
Indexers Won’t Race To Be The First
Given the size and potential commercial importance of the Chinese market for index firms, could there be a competitive race amongst providers to see who can include A-shares first?
“We will make our decision based upon the merits of the issues and competitive pressures won’t have an impact,” said MSCI’s Chin Ping Chia.
“The key thing is whether the A-share market is developed enough to merit inclusion and we won’t be afraid to disappoint investors if we feel it isn’t.”
David Blitzer, head of S&P Dow Jones’s index committee, also stressed the importance of getting A-share index inclusion right, rather than doing it quickly.
“There may be a general investor audience out there that could get excited about the prospect of including China first, but institutional investors would be concerned about the turnover, costs and disruption of any index change,” Blitzer told ETF.com.
“China’s big, so including A-shares will shift a lot of weight within institutional portfolios. Our focus is on doing things smoothly.”