In May of 2018, just weeks prior to the launch of China A-shares being added to the MSCI Emerging Markets Index, Penserra published “Fifty Shades of A: Can the MSCI Inclusion of China A-Shares Be Trusted by Institutional Investors.” Included in that article was the following statement: “While some investors are still haunted by memories of China’s 2015 stock market crash, a deeper fear of missing out is expected to boost investments in Chinese mainland stocks.”
Recent developments suggest we were correct in our assessment. However, in meteorological terms, we were forecasting a few light showers. What we’re witnessing instead has the makings of a tsunami.
Factor #1: An Acceleration by MSCI
The first step of the inclusion involved 222 large-cap China A-shares with an Index Inclusion Factor of 2.5% of the market capitalization in the MSCI China Index. That represent a weight of approximately 0.37% of the pro forma MSCI EM Index. Three months later, on September 3, 2018, the Index Inclusion factor was raised to 5%, resulting in a MSCI EM weighting of 0.74%.
The third step of this implantation originally involved quadrupling the Index Inclusion factor to 20%, by May 2020, and thus the MSCI EM weighting would rise to 2.82%. However, MSCI started consulting last September with asset managers on increasing the weighting in China A-shares, and the results indicated that institutional investors were keen to see China become a bigger part of the global financial ecosystem. Because of the success of the original two-step inclusion, and the fact Beijing has opened its markets to foreign investors in recent years, full implementation of the third step was moved up to November 2019. In reaction to the fast-tracking process, Remy Briand, MSCI Managing Director and Chairman of the MSCI Index Policy Committee, said “The successful implementation of the initial 5% inclusion of China A-shares has been a positive experience for institutional investors and has fostered their appetite to increase further their exposure to the mainland China equity market.”
Factor #2: Addition of Mid-Cap Shares
Penserra’s May 2018 article also included the following statement: “Beyond raising the index inclusion factor… the possible addition of mid-cap stocks will be an imminent next step on the index provider’s future inclusion roadmap.”
In consultations with many international and domestic institutional investors, a significant proportion highlighted that China A Mid-Cap shares should be included in MSCI indexes jointly with the weight in large cap shares to allow for a smoother implementation. Mid-Cap proponent also proposed the addition of ChiNext stocks, a NASDAQ-style board of the Shenzhen Stock Exchange.
“Some investors did not want to wait so long for mid-cap inclusion, so we decided to bring it forward,” said Chin Ping Chia, Head of Asia-Pacific research at MSCI.
Implementation: The MSCI Three-Step
MSCI plans to increase the inclusion factor in three steps, with increments taking place in May, August, and November. These steps include:
Step #1 (May): MSCI will increase the index inclusion factor of all China A-Large Cap shares in the MSCI Indexes from 5% to 10% and add ChiNext Large Cap shares with a 10% inclusion factor coinciding with the May 2019 Semi-Annual Index Review
Step #2 (August): MSCI will increase the inclusion factor of all China A-Large Cap shares in the MSCI Indexes from 10% to 15% coinciding with the August 2019 Quarterly Review
Step #3 (November): MSCI will increase the inclusion factor of all China A-Large Cap shares in the MSCI Indexes from 15% to 20% and add China A Mid-Cap shares, including eligible ChiNext shares, with a 20% inclusion factor to the MSCI Indexes coinciding with the November 2019 Semi-Annual Index Review.
Upon completion, the MSCI EM Index will include 253 Large-Cap and 168 Mid-Cap China A-shares, including 27 ChiNext shares, resulting in a weighting of 3.3%.
Conclusion: A Bull Case for China
Expanding the weighting of China A-shares could see billions of dollars flow into one of the world’s most volatile stock markets. Without specifying a time frame, Goldman Sachs Group suggests $70 billion of net buying to A shares, while T. Rowe Price Group says $40 billion could flow from active funds. This is significant when considering the CSI 300 Index of stocks listed in Shenzhen and Shanghai have already climbed approximately 20% during the first two months of 2019.
“There’s been a pretty dramatic shift in both the circumstances and mindset in roughly the last three to four years,” says Baer Pettit, president of MSCI. “Western managers have realized that this China thing is real.”