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The Evolution of The Chinese Equity Market (Part 2)

How large will China’s share of these indices become? It seems that the best answer is “larger” and potentially, “much larger”.

Jackie Choy 30/04/18

In part 1 of this article, we looked at how the Chinese equity market have changed over time. In part 2, we are going to look at what the future might hold.

What Might the Future Hold?
Change is the only constant. Indexes are living, breathing creatures that evolve in sync with the economy and the markets. Nonetheless, some changes are “man-made” and, in the case of the MSCI China Index, one such series of changes is well-known and fast-approaching. In June 2017, MSCI announced that it will include 222 Chinese A-Shares in the MSCI Emerging Markets Index in a two-step process that will commence in May 2018. Using June 2017 figures, A-Shares would make up 0.73% of the MSCI Emerging Markets Index once they’ve been folded in. All remaining Chinese shares would represent 28.5% of the index’s value (using June 2017 figures). Chinese A-Shares would represent 2.5% of the MSCI China Index (again, using June 2017 figures) once all is said and done. For more detail, please refer to our prior research, “MSCI Takes a Small Step Toward Bringing One of the World's Largest Markets Into the Fold”.

This is just the start. MSCI has provided a roadmap, though no specific timelines, outlining the next milestones for China A-Shares inclusion. These could include: 1.) increasing the 5% inclusion factor and; 2.) the addition of China A mid-cap stocks. While the timing is unknown, it seems all but certain that, ultimately, China A-Shares’ representation within the MSCI Emerging Markets Index and MSCI China Index will increase.

As Chinese stocks’ footprint continues to expand in equity indices to more closely align with the footprint of the nation’s capital markets and its economy, some investors may be asking (among other things) – “How large will China’s share of these indices become?” At present, China’s 3.6% share of the MSCI ACWI represents a large disconnect relative to its 14.8% share of global GDP (per 2016 data from the World Bank). By way of comparison, U.S. stocks make up 52.0% of the MSCI ACWI and the country’s share of global GDP was 24.6% in 2016. Thus, it seems that the best answer to the above question is “larger” and potentially, “much larger”.

Given the expanding influence of China A-Shares in Chinese equity indices, investors should work to better understand the fundamentals of the A-Share market. Our Morningstar Global ETP Reports have a “Fundamental View” section where we provide a broad overview of the underlying macroeconomic fundamentals that will affect the ETF’s performance. These reports on ETFs with Chinese A-Share exposures should help investors navigate through some of the nuances in this asset class. Our equity analysts’ research analyses on specific A-Share companies can also assist investors in understanding the fundamentals of the individual stocks as well as the relevant sector.  Investors should also note that as the China A-Shares are added to the existing MSCI China Index, industry weights will also change, especially if and when mid cap stocks are added to the mix.

Exhibit 7 shows the rolling 3-year correlation of the MSCI China Index and the MSCI China A Index versus the MSCI World Index dating back to January 2001. The MSCI China Index’s correlation with the MSCI World Index averaged 0.77 during this period. This is indicative of some degree of potential diversification benefit for global investors. However, the future direction of this relationship is difficult to predict given the addition of the A-Shares. This is because A-shares have historically experienced a lower level of correlation to the MSCI World Index as compared to that of the MSCI China Index. Over the past nine and a half years, the correlation between the MSCI China A Index and the MSCI World index was 0.40. If we simply extrapolate this historical relationship into the future, the increasing share of A-Shares composition in the MSCI China Index would, in theory, reduce the correlation of the MSCI China Index with the MSCI World Index, implying greater diversification benefits. However, from a broader perspective, the further opening up of the Chinese equity markets as well as continued globalization and expansion of trade between China and the rest of the world, will make Chinese ever more global. These factors will likely serve to increase the correlation of the MSCI China Index with the MSCI World Index in the long run, hence reducing the diversification benefit for global investors.

Key Takeaways

1) The Chinese equity market has evolved and will continue to do so. With the inclusion of Chinese A-Shares and possible future inclusion of mid-cap stocks, emerging-markets indexes will likely further increase their concentration in the Asia region, and China in particular.

2) How large will China’s share of these indices become? The further opening up and evolution of the Chinese market will help China’s weighting within international indices to grow into the nation’s true economic footprint. Thus, it seems that the best answer to the above question is “larger” and potentially, “much larger”.

3) The further opening up of the Chinese equity markets as well as continued globalization and expansion of trade between China and the rest of the world, will make Chinese ever more global. These factors will likely serve to increase the correlation of the MSCI China Index with the MSCI World Index in the long run, hence reducing the diversification benefit for global investors.

About Author Jackie Choy

Jackie Choy  

is the director of ETF Research for Morningstar Investment Management Asia