Keep Calm, China A-Share Investors

LONDON – A number of significant developments have taken place in recent years in relation to China's liberalization of its capital markets. The magnitude of some of the key changes, such as the expansion of the Renminbi Qualified Foreign Institutional Investor Scheme (RQFII), and the introduction of the Shanghai-Hong Kong Stock Connect programme, have been unprecedented. They have also exceeded the expectations of many investors.

In light of recent market turmoil however, some investors may expect that the Chinese government could be diverted from further reform. This view is balanced by other investors who remain optimistic on the continued opening up of the Chinese market. In a recent report from Deutsche Bank research dated 24 September (China in Global Indices – Significant Changes are in Sight), analysts were optimistic that the reform pace will accelerate again once market conditions have stabilized.

China A-Shares Broaching Global Indexes

MSCI's potential inclusion of China A-shares into its main emerging markets index (MSCI EM) is one of the hot topics of discussion amongst investors. In their last two annual reviews, MSCI decided not to include China A-shares but to keep the asset class on the watch list. If MSCI decides to include China A-shares (which would start with a small weighting) in June 2016, Deutsche Bank research believes that the first change will likely be implemented in May 2017.

Changes are already underway. MSCI has confirmed it will add American Depositary Receipts (ADRs) to the MSCI EM Index starting next month, including companies such as Alibaba and Baidu. Deutsche Bank research estimates that with this change in place China's weight in MSCI EM will increase from its current level of approximately 23.5 percent to 26.2 percent by May 2016, when the inclusion of ADRs will be complete.

In 2017, China's weight will increase to approximately 28.5 percent, of which China A-shares should represent 2.2 percent and ADRs 3.5 percent. Full inclusion of China A-shares should increase China's weight to 40.5 percent of the index.

In the event that Korea and Taiwan are promoted to the developed markets universe, China's weight should increase to over 50 percent of the MSCI EM index. As a result, China could potentially see $40 billion inflows in the short term, assuming 10 percent inclusion of China A-shares, and up to $340 billion of inflows assuming full inclusion by MSCI, according to our research.

Obstacles To Investing In China Remain

While Chinese authorities have made significant progress in opening up the domestic equity market, some obstacles still exist, which prevent fund managers closely replicating or benchmarking to a global index that includes China A-shares.

Foreign investors still face certain restrictions when accessing mainland markets and further reforms would need to take place to break down these barriers. There have been reports in the media about the upcoming Shenzhen-Hong Kong Stock Connect programme and the harmonisation of QFII and RQFII rules. Deutsche Bank research views these changes as pre-requisites for MSCI to announce the inclusion of China A-shares.

Recent Volatility Will Not Affect A-Share Inclusion

Recent market turmoil and implementation of a number of governmental measures to stabilise their equity market have been noted by foreign investors. This intervention included the suspension of almost 50 percent of A-shares stocks from trading at the peak of the volatility in July 2015, and not allowing major shareholders to sell shares. Deutsche Bank found that the number of such stocks has almost dropped to the pre-market-slump level (graph below), while the prohibition on major shareholders selling shares will expire in December 2015.

We believe that temporary accessibility issues will not impact MSCI's decision on the inclusion of China A-shares. In fact, the closure of a stock exchange for less than 40 consecutive business days does not lead to action from MSCI. Recent examples in Greece (closed for over 30 days in 2015) and Egypt (closed for about 40 days in 2011) further supports this observation, as both countries are still included in the MSCI EM index.

While one can argue that these countries are already in the index, previous cases show that MSCI's rule of no action for 40 days before launching a consultation suggests that suspension and even market closure are not uncommon in emerging markets.

The timing of the inclusion of China A-shares in wider equity indexes depends on the speed of liberalisation of China's equity market. If progress were to be unexpectedly held up and the situation did not improve for a long time, then the impact could be significant. In 2008, MSCI removed Pakistan from its emerging markets index four months after the country imposed the "floor rule," which effectively shut down the market. But in China, we don't expect the same event to take place. In fact, we remain optimistic that as the market stabilises, Chinese regulators will implement the much-needed reforms.

Anson Chow is head of exchange-traded product development, Asia-Pacific, at Deutsche Asset & Wealth Management