What's happened?
MSCI announced on June 9, 2015 ET (June 10 am HKT) that China A shares will not be included in the MSCI Emerging Markets Index as part of its 2015 Annual Market Classification Review.
At the same time, MSCI and the China Securities Regulatory Commission (CSRC) will form a working group to facilitate discussion and aim to resolve investors' concerns regarding investing in the A-share market, including quota allocation process, capital mobility restrictions and beneficial ownership of investments.
MSCI also stated that it may announce the decision to include China A-shares in the MSCI Emerging Markets Index as soon as the issues it has outlined are resolved and this may happen outside the regular schedule of its annual Market Classification Review.
It is a surprise?
No, in our view.
In our report China Strategy: The case for re-rating (Part 4): Index matters, April 29, we put a 50% probability for June 2015 inclusion. Additionally, our recent conversations with international investors also suggested that their expectations for June inclusion were low. Indeed, in early May, a MSCI spokesperson explicitly mentioned that MSCI may not adhere to its usual operating cycle for major index events (i.e. announcement in June and implementation in the following May) if they see significant changes in market conditions which warrant a more flexible, off-cycle approach. This suggested to us that the June inclusion wasn't a high probability event, but...
...4Q15 inclusion is still on the cards
Despite the favorable size (second largest globally), liquidity (most actively traded cash market globally), and policy (a number of key capital market liberalization measures have been made) arguments, one of the key obstacles going against the inclusion is that international investors can’t access Shenzhen-listed stocks, which represent 41% of total A-share market cap, in an open and unobstructed manner unless they are eligible for and granted (R)QFII quotas.
Our expectation is that the SZ-HK Connect scheme could be unveiled in the near future and could be up and running in 4Q15. If our expectations prevail, a key pre-requisite for A-share inclusion to global indices will be fulfilled, and could open a special review by the MSCI, in our view.
Additionally, we note a rising reception of embracing A shares by index compilers and investors. On May 26, FTSE announced the creation of 2 transitional (R)QFII Emerging Market indexes which aim to facilitate the potential inclusion of A shares to FTSE’s standard global indexes. On June 2, Vanguard announced that its EM ETF (VWO, AUM of US$67bn) will switch from FTSE Emerging to FTSE Emerging All Cap China A Inclusion Index where A shares represent 5.6% of index weight. According to FTSE, 'China' could potentially represent close to 60% of EM in FTSE on full A-share inclusion.
Bottom line: A question of when, not if. China could be 1/3 of EM and APJ investors' benchmark in 2 years
Instead of focusing on the exact timing of the inclusion, we believe it’s sensible for investors to take a medium-term view and understand how their benchmarks will evolve over time. Fast-forwarding to mid-2017, we estimate that 'China' could represent 1/3 of EM and APxJ investors’ benchmark by aggregating the current index cap of MSCI China constituents (i.e. H shares, Red Chips, and P Chips), the confirmed inclusion of overseas-listed Chinese companies in the US, and the potential announcement of A-share inclusion in the next 6 to 12 months assuming an initial inclusion factor (IF) of 10%.
Given our assessment that global investors by various mandates are still meaningfully underweight Chinese stocks, and the potential increases of China's index weight over the next 12 to 24 months, we continue to expect
strong passive flows into and active allocation/positioning normalization demand for Chinese equities. See Asia-Pacific Strategy: Asia fund positioning: Funds still UW China post the rally, May 31.