China has made great strides in recent years. In 2011, its economy surpassed Japan's for the number two spot in global rankings based on GDP1, and one estimate projects that China will surpass the U.S. economy in size before 2030.2
As portfolio managers of an emerging-market equity strategy, we view this growth as a broadening of the range of bottom-up investment opportunities in China over the medium to long term. We are currently able to access many—but not all—of these opportunities through shares issued by Hong Kong-listed mainland Chinese companies and U.S.-listed American depositary receipts of selected Chinese firms. With certain limitations, foreign investors can also access China's domestic equity market through the Hong Kong Stock Connect, a program launched in 2014 allowing foreigners to trade shares on mainland exchanges in Shanghai and Shenzhen, while also permitting certain mainland investors to trade stocks listed in Hong Kong.
While these channels enable limited foreign access to China's domestic equity market, they will not bring about the much broader access needed to give China a presence in global markets that is proportional to its vast and growing economic strength. Without that access, China is limited in its ability to tap the global capital needed to fully realize the potential of its economy and its population of nearly 1.4 billion.3
These limitations are evident in the weightings of Chinese stocks in global market indexes and, consequently, in most investors' portfolios; they are puny relative to the size of China's economy. While its economy makes up nearly 18% of global GDP4 China's weighting in the MSCI All Country World Index is just 3%.5
A step forward for China
A June 20 announcement by MSCI Inc. will begin to shrink this imbalance over the coming years, and marks a critical step toward accelerating China's integration into the global financial system. After deliberating for more than three years over market access issues and other concerns, U.S.-based MSCI announced that it will begin including China's domestic equity market shares, known as A-shares, in the MSCI Emerging Markets Index and the MSCI All Country World Index.
The inclusion of A-shares will begin on a small scale in June 2018, starting with 222 large-cap stocks that are already accessible to foreign investors through trading links with Hong Kong. The initial weighting of the additions to the MSCI indexes will be marginal; the 222 stocks will comprise just 0.7% of the MSCI Emerging Markets Index. As it considers additional steps to expand inclusion of A-shares, MSCI plans to continue monitoring China's progress in meeting international market accessibility standards; it will likely be several years before A-shares traded on mainland exchanges in Shanghai and Shenzhen secure a weighting that is anywhere close to being proportional to China's economic strength. However, with MSCI's announcement, China has taken a step forward in global markets.
Why does inclusion matter?
Mutual funds and other assets that are indexed to the MSCI Emerging Markets Index total about $1.5 trillion,5 and these investors will begin to make allocations to A-shares to reflect the composition of the index, as well as the MSCI All Country World Index. Today, China is the largest country component in the MSCI Emerging Markets Index, with a nearly 28% weighting.5 In my view, a full opening of the A-share market to foreign investors could eventually result in China's weighting exceeding 40%. This could result in potentially hundreds of billions of dollars flowing into Chinese companies with stocks listed in Shanghai and Shenzhen, and many non-Chinese investors' allocations to Chinese equities would increase as A-shares are included in more global indexes.
Implications for China
In my travels to China, I have seen the remarkable growth in Chinese consumers' spending power, reflected, for example, in areas such as e-commerce and the wide adoption of smart mobile devices. I expect the growth of China's middle class will continue, creating a proliferation of bottom-up investment opportunities in Chinese stocks. The opening of the A-shares market to foreign investors will gradually eliminate barriers that had restricted access to many of these opportunities. Eventually, China hopes to expand the role of foreign investors in its bond market, as well. The MSCI decision on A-shares and the further liberalization that it could bring about are emblematic of the potential of China's far-reaching economic reform program and the nation's emergence as a key pillar in the global financial system.
2 The World in 2050, PwC, 2017.
3 The World Factbook, U.S. Central Intelligence Agency, 2017.
4 World Economic Outlook, International Monetary Fund, 2017.
5 MSCI Inc., 2017.
The MSCI Emerging Markets Index tracks the performance of publicly traded large- and mid-cap emerging-market stocks. The MSCI All Country (AC) World Index tracks the performance of publicly traded large- and mid-cap stocks of companies in 23 developed markets and 23 emerging markets. Total returns are calculated gross of foreign withholding tax on dividends. It is not possible to invest directly in an index.