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RMBi: Small weightings make a big difference

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By Noah Sin
29 Jun 2017

The entry of A-shares into MSCI’s emerging market index was quickly dismissed by China bears as a non-event, given the tiny weighting Chinese equities will have in the index. But sceptics should learn from history that small weightings often make a big difference to RMB internationalisation — and MSCI’s A-share inclusion might just be an example of that.

After three rejections, Chinese A-shares finally made it into MSCI’s EM index on June 12. While some have been cracking open champagne bottles since, critics have been quick to point out that the inclusion was at best symbolic, given merely 222 stocks are included, making up 0.73% of the index. Some went as far as saying that MSCI’s move was political. After all, what difference has 0.73% of anything ever made? Surely this is just another attempt to appease China.

This narrow view misses the long term picture of A-share inclusion. First, A-shares’ weighting will not stay at 0.73% forever. It has an opportunity to grow at every successive review of the index by MSCI. Given that global investors are currently underinvested in the Chinese equity market, the second largest in the world, that number is only going to go up. Some analysts are already expecting stocks in South Korea and Taiwan, which up until now have been A-share proxy stocks, to be edged out of the index in the future.

Second, 0.73% only represents the scale of passive money that could come to China after the inclusion. The bulk of inflows will be driven by active managers, which will try to beat the benchmark by either being overweight or underweight China. Given how little exposure global investors have to A-shares, at under 2% of the overall market, the MSCI weighting is quite a low bar to reach.

It is a fact, however, that MSCI’s decision only serves as a non-binding indicator for these active managers. Whether the cash will come is an open question.

Yet the same arguments were made when the RMB was included in the International Monetary Fund’s special drawing rights (SDR) basket with a weighting of 11% in October 2016. Today, the European Central Bank has €500m of its reserves in RMB, which it switched dime for dime from the dollar earlier in June. The Bank of International Settlement (BIS) also holds 11.1% of its reserves in RMB, mirroring the SDR basket, as disclosed in its latest annual report.

Besides, an analysis that stops at the 0.73% figure fails to take into account the magnitude of reform that A-share inclusion is likely to bring.

Within a week of MSCI’s decision, China Securities Regulatory Commission (CSRC) has already hinted that it is considering changes to the Stock Connect’s daily trading limits and sounding out the idea of introducing new derivatives in the offshore market.

Admittedly, regulators can go back on their words. But the reform train is already in motion. As international investors reallocate their funds to A-shares as a result of MSCI’s decision, they will need to ensure their investments also comply with home regulations. This includes those of the US Securities and Exchange Commission and other regulators with much stricter requirements of transparency and higher standards of investor protection than those currently required by Chinese regulators.

The inclusion will not only affect regulators but Chinese listed companies as well. As A-shares expand their presence in global investment indices, more and more Chinese companies will have no choice but to live up to those global standards if they want a piece of the inclusion inflows cake. This could lead to a renewed push for transparency and improved governance in the market and help align Chinese equities with international markets.

This will no doubt be a long process. And granted, there will be a lot of back and forth on reform, and Chinese regulators have already proven they are ready to roll back relaxations when market stability is threatened. But, overall, MSCI’s decision is just the beginning, not the end, of a new chapter of RMB internationalisation.

By Noah Sin
29 Jun 2017