Index inclusion gives impetus to investment in China’s A-shares

When MSCI finally included the first batch of A-shares in its emerging markets index in June, it pushed a broad range of international investors to dip their toes in Chinese stocks for the first time. But as speculative retail flows continue to dominate the market, some are turning to opportunities outside the benchmark. Noah Sin reports.

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There were smiles all round at the Shanghai Stock Exchange on May 31 when Henry Fernandez, CEO of MSCI, made a trip to the city to mark the official inclusion of A-shares in the MSCI emerging markets index.

China had plenty to celebrate. After three failed attempts in as many years prior to 2018, these Chinese stocks had finally made it into a benchmark that, as of last Decem­ber, is tracked by $1.9tr of funds, according to the index provider’s data. On the day Fernandez visited, the Shanghai Composite Index (SHCOMP) closed at 3095.47 points, up 1.78% from the previous session, according to the exchange.

But less than a month later, the market was suddenly in retreat.

On June 18 the US president, Donald Trump, threatened to put tariffs on $200bn of Chinese goods – news which wiped 6% off the Shanghai index the next trading day. A week later the stocks hit bear territory – losing 20% in value for the year to date – as Beijing and Washington raised the stakes in the trade war.

The events of 2015, when Chinese stocks last went into a free fall, loomed large. To make matters worse, the White House is now occupied by a far less predictable master than three years ago.


Until recently, relatively few international investors would have worried about these twists and turns in Chinese equities. Offshore investors held Rmb1.17tr ($174.8bn) of onshore equities last December, up substan­tially from Rmb700.2bn at the beginning of 2017, according to the latest annual report of the People’s Bank of China. But the amount is minuscule compared to the overall Chinese market, which was worth Rmb56.7tr in December 2017, Wind data shows.

The MSCI inclusion is set to change this. Only 226 A-shares are included this year, among them, liquor-maker Kweichow Moutai and state-owned lender Bank of China, but Laura Wang, equity strategist at Morgan Stanley, believes full inclusion could happen within a decade, bringing $60bn-$70bn of inflows from passive investors alone.

Turnover on the northbound channels to the Shanghai and Shenzhen stock markets more than doubled to Rmb227.9bn and Rmb183.7bn respectively in July, from Rmb101.1bn and Rmb73.3bn at this point last year, according to data from Hong Kong Exchanges and Clearing (HKEX).

“The active momentum will be even stronger,” Wang tells GlobalRMB.

China is also widening the investor base for A-shares beyond local investors. The China Securities Regulatory Commission (CSRC) proposed new rules on July 8 to allow expa­triates in China, as well as overseas-based employees of A-share listed companies whose incentive schemes include stocks, to tap the market.

As global investors increase the weightings of Chinese stocks in their portfolios, how will they navigate the Wild West onshore market? Wang reckons most investors will stick to what they know best, namely the blue chips.

“Foreign investors are more interested in stocks with strong fundamentals,” she says. “We have been recommending investors to identify the industry leaders in this market. If you look at northbound flows under Stock Connect, it’s quite clear that most of the flows are going into these stocks.”

International investors like to buy blue chips because they are more predictable, and in that sense, more like their global peers, says Vincent Chan, head of China equity research at Credit Suisse.

“In terms of valuation, these large caps are trading more and more like global stocks, with their valuation based more on earnings, because they are getting more institutional flows,” he says.

But blue chips are not for everyone. John Lin, China portfolio manager at Alliance­Bernstein, likes stocks that are not yet on the radar of global managers.

“This is an opportunity for global funds to enter the mid- to small-caps space,” he says. “We could buy names which most investors in Europe wouldn’t have even heard of. You can have a sizable asset return above and beyond the benchmark, and that is [an opportunity] that international investors recognise.”

Not that Lin has anything against the bigger names. In recent years, he has held a couple of blue chips that make baijiu, or white liquor, China’s favourite spirit and a popular gift, to capture the industry’s rebound from the anti-corruption crackdown in 2013. But his focus is shifting as these large caps reach a high valuation and become more widely owned by institutional investors.

“Mid- to low-end white liquor-makers are now seeing the benefits of the industry recovery, with a lag to the premium brands,” he says. “Smaller-cap names such as Beijing Shunxin Agriculture, which makes a low-end but popular white liquor, or Anhui Kouzi Dis­tillery, another regional white liquor-maker, have very solid revenues and earnings growth trends that have been under-appreciated by the market.”

The Chinese market is particularly attractive to active managers because of its unsophisticated investor base, says Hong Hao, head of research at Bank of Communi­cations International, who notes that almost 70% of onshore accounts are retail.

“Market sentiments are very fickle,” he says. “Because of the large retail presence, Chinese institutional investors behave more or less the same as the retail guys. This is a playground for active fund managers.”


There is a way for foreign investors to buy Chinese names without exposing themselves to the rollercoaster ride of the Shanghai and Shenzhen markets. Some of these companies are, in fact, dual-listed in China and Hong Kong, and their offshore shares, known as H-shares, are often cheaper – to be precise, 20% cheaper as of June, according to Hong.

The higher valuation of A-shares is a reflection of the abundance of liquidity in the onshore market, which occurs because of capital controls, says Credit Suisse’s Chan.

“There is too much money in China because people don’t have many channels to invest,” he says. “You won’t find many mainland investors in London or the US market, and only a portion of the pool are in Hong Kong.”

Wang also attributes the A-share premium to capital controls but notes that dual-listed companies form only a small portion of the onshore market. As of late July, there are 142 constituents in the Hang Seng Stock Connect China AH Index, which includes all compa­nies simultaneously traded in A-share and H-share markets: to put that in context, there are 1,479 listed stocks in Shanghai alone.

The picture also looks different when the whole of the Chinese market is taken into account.

“Currently, A-shares are actually trading at par or marginally cheaper than the offshore market if we compare the 12-month forward price-to-earnings of the two markets,” she says.


Nevertheless, the underlying cause of the A-H spread – that local investors have nowhere to put their cash, pushing up prices – highlights the macro challenges facing foreign investors. Lin believes they should ask three key questions before committing to this market: “Do I trust the government on capital control? Do I trust the company on corporate governance? Do I trust the econ­omy – that it wouldn’t get into a downturn?”

For Hong, the danger around the corner is the rising rate of defaults.

Chinese companies defaulted on Rmb54bn of bonds between January and the middle of August this year, compared with Rmb21.7bn in the same period last year, Wind data shows. Meanwhile, Moody’s research shows that Rmb2tr of corporate bonds were due to be refinanced as of March 2018.

The latest additions to this list include a bond issued by Leshi Internet Information and Technology Corp, the debt-saddled internet company whose assets were frozen, along with its founder’s personal assets, by a court in Shanghai last year, according to state media.

Growing risks in the bond market could shake equities unless Chinese companies find new ways to refinance outstanding debt. “We have a wave of corporate defaults, including some by very well-respected companies of substantial size,” he says. “The macro risk is very high.”

Chan also sees defaults as an imminent threat. But for him, the biggest uncertainty comes not from refinancing pressures, but regulators’ willingness to let companies default in the first place.

“We don’t know how far the government will go,” he says. “Will it stop with the private companies? Will the state-owned enterprises or local government financing vehicles default? These are the kind of questions that could create shocks in the market.”


While regulators still have more work to do in addressing these concerns, they have come a long way from just three years ago, when China first launched Stock Connect, a scheme that allows international investors to tap onshore stocks with accounts in Hong Kong.

Even though China put a cap on the daily trading volumes on the equity link, it has not locked up Stock Connect investors’ cash or halted trading when the market looked bearish. In fact, the PBoC did the opposite in May, raising the cap on net daily purchases on Stock Connect to Rmb52bn from Rmb13bn for northbound and to Rmb42bn from Rmb10.5bn for southbound.

This careful management of Stock Connect was what clinched it for A-shares regarding MSCI inclusion, says Lin.

“That Stock Connect has been untouched by the authorities shows that capital control is not a big concern,” he says. “Even in the midst of the crisis in 2015 and 2016, at no point did the Chinese authorities mess with the Stock Connect. They may close the capital account on retail investors, but they have maintained the integrity of the investment channels for international institutional investors.”

There have been exceptions though: the Shanghai and Shenzhen stocks exchanges shut Xiaomi, the mainland mobile maker which recently listed in Hong Kong, out of Stock Connect. They justified the move by claiming that onshore investors are not famil­iar enough with the weighted voting rights (WVR) structure to trade the stock. Xiaomi was the first company to use the structure in Hong Kong.

This was the first time China stopped a specific stock from entering the equity link, triggering a rare public row with HKEX. Lin, a sceptic of WVR, is unfazed.

“The mainland exchanges’ decision really shouldn’t be considered as any tinkering with the integrity of the Connect scheme,” he says. “There are other considerations at work, one of which is a legitimate question on corpo­rate governance and protection of minority shareholder rights.”


Many investors have decried the Chinese regulators’ market meddling since 2015, but at least as many are disappointed with the lack of progress on the issue of stock suspensions. Investors and index providers have repeatedly raised the need for Chinese authorities to improve the rules, often abused in their current form, that govern listed companies’ ability to suspend their own stock from trading.

MSCI kicked seven stocks out of the inclusion list at the eleventh hour because they were suspended. One of them was ZTE Corp, the Chinese telecom equipment maker, which suspended trading in Hong Kong and Shenzhen as the US Department of Commerce placed a seven-year ban on the firm from getting components from US companies.

Regulators are aware of this problem. In a speech on June 14, Fang Xinghai, deputy chairman of CSRC, said that the regulator is considering a mechanism to regulate suspen­sions, with the goal of raising the inclusion factor of A-share in the MSCI EM index to 15% from 5% currently. MSCI had said last June that further inclusions would indeed depend on progress with cleaning up the practices around stock suspensions.

Policymakers are genuine in their desire to turn things around, says Wang from Morgan Stanley. Figures from Wind data compiled by the bank shows that there were 1,439 suspended stocks, which represented 49.9% of A-shares, as of July 9, 2015. The number dropped to just 206 stocks, or 5.7% of the asset class, by May 29, 2018.

“[Any suspension] very much affects tradability of A-share market,” Wang says. “The onshore regulators have been paying attention to that. They are not quite there yet, but things are kept under control. The ratio of suspended stocks versus total stocks has come down significantly over the last two and a half years.”


These obstacles should not be overlooked. But in the grand scheme of things, as China continues its quest to open up its financial markets— mostly recently by lifting the cap on foreign ownership in the financial sector — international investors will find China easier to navigate , says Hong, who worked in New York and Sydney before witnessing China’s economic take-off close up.

“When I came back to China 10 years ago, the market was very different,” he says. “Things will also be very different 10 years from now when we see the results of the reform.”

If the past is any guide, things may get better sooner rather than later, and in ways that may surprise both foreign and domestic investors, Lin says.

“No one would have predicted MSCI inclu­sion and [the launch of] Stock Connect five years ago,” he says. “I am sure by the time we get to 2023 there will be acronyms [for new access schemes] that are commonly used in Chinese capital markets that do not exist today.”

In Shanghai, things seem to have calmed down a little. SHCOMP closed at 2876.40 points on July 31, a rebound of 5.2% from the low of 2733.88 points on July 5. But much still hangs in the balance.

Trump shows no sign of walking back from his tariff threats. In July, China appeared to be taking the foot off the accelerator in its deleveraging campaign and loosening the money supply – but not before the PBoC and the finance ministry engaged in a public war of words over the direction of fiscal policy. So for now, uncertainty is the order of the day.

It may be true that the Chinese market is destined for further liberalisation, but foreign investors should prepare themselves for many more sharp turns on this journey before they get to the promised land.