Monday 18 June 2018

With its equity market opening faster than ever before and bonds soon to follow, investors should act now on China.



China has dramatically accelerated its efforts to open its financial markets to outside influence, with both equity and bond markets poised for inclusion in global indices. After years of signals that real change was imminent, there is now no question for global investors around when to enter China. Big shifts are taking place in investor portfolios across the globe following two major announcements, which are changing China's role in the global economy:
  1. The inclusion of A-shares into the MSCI Emerging Markets Index in June 2018 and;

  2. The scheduled inclusion of Chinese Bonds in the Bloomberg Barclays Global Bond Index in April 2019
A-share allocation is expected to grow from the initial less than 1 per cent (or 233 stocks) over time, says Manishi Raychaudhuri, Head of Equity Research for Asia Pacific at BNP Paribas.

"If and when that 5 per cent goes to 100 per cent the rate of Asia's MSCI emerging market will go to a little more than 16 per cent from 0.81 per cent currently. I use the word 'if' because there are certain conditions that need to be satisfied," says Mr Raychaudhuri.

He says predicting "when" is dependent on China's ability to address two key issues.

"It is almost impossible to naturally predict a timeline for that 5% inclusion factor to increase.
"Eventually when that inclusion factor increases, the weight of A-shares and the weight of China overall would be a dominant part of any of the benchmark indices."
Manishi Raychaudhuri, Head of Equity Research for Asia Pacific at BNP Paribas
Rather than looking at a concrete timeline, it's better to focus on certain requirements from authorities that will allow MSCI to include them. They would like to see a significant degree of decline in the number of stock suspensions and number of days over which the stock is suspended. They are also looking at the access avenues being expanded considerably. What's not difficult to figure out is that eventually when that inclusion factor increases, the weight of A-shares and the weight of China overall would be a dominant part of any of the benchmark indices."

Jason Lui, Head of Equity and Derivative Strategy Asia Pacific at BNP Paribas says global equity investors can be broadly categorised into three camps at this time of momentous change.

"First we have the passive funds that follow the index and will be focused on execution. Then there are the active managers that already have some exposure to China but after inclusion they're not sure how the passive flows are going to help or hurt their portfolios," says Mr Lui.

The last group are those that would prefer not to be in China at all, daunted by the unknown and not sure exactly where and how to build a position.

""These investors can't afford to wait on the sidelines any longer and that is why inclusion, and the expectation that weightings toward Chinese A-shares will continue to build, make it such an exciting time,""
Jason Lui, Head of Equity and Derivative Strategy Asia Pacific at BNP Paribas

A small beginning with a long-term impact

From June 1 2018, 233 large cap China A-shares will be added to the MSCI Emerging Markets (EM) Index from an initially-proposed number of 222. Foreign institutional investors' increasing participation in A-shares could create opportunities and help institutionalise the domestic market.

The China A-Share market is the most active cash equity market in Asia Pacific with US$48 billion of average turnover per day meaning most of the constituents for MSCI C inclusion have good liquidity, with three quarters of the stocks trading more than US$50 million per day.

"We expect up to US$20 billion worth of passive and active index rebalance inflow," says Mr Lui. "Not only will this boost China's creditability as a global economic power, but it will also help to increase global fund inflows into the domestic market."

While this is just a small beginning, it has a potentially long-term impact where the ramifications of A-Share inclusion are manifold:

  1. Not only is A-Share inclusion an important step towards internationalisation of the RMB, it should also serve as a prompt for international investors to look at A shares more closely.
  2. The A-shares that are being considered for inclusion are from sectors significantly different to those comprising MSCI China or HSCEI. With an increasing inclusion factor, the universe of Chinese stocks available to international investors would be considerably different to that available today.
  3. MSCI's methodology for inclusion of A-shares in its set of eligible stocks ensures an incentive for trading processes in onshore Chinese equity markets to become more sophisticated – e.g. trading suspensions could be reduced considerably.

The Chinese bond market is too big to be ignored

China's financial sector is ready for further inroads by foreign investors and in its latest effort to develop its bond market, Chinese RMB-denominated government and policy bank securities are set to join the Bloomberg Barclays Global Bond Index for the first time in 2019. The addition of these securities to the world's third-largest bond market will be phased in over a 20-month period, with a scaling factor of 5% and increasing in 5% increments each month following, and will represent 5.49% of the index.

Marking another milestone in the path to financial sector liberalization, the local currency Chinese bonds will be the fourth largest currency component following the US dollar, euro and Japanese yen. It also signifies confidence from Chinese authorities that domestic financial institutions are strong enough to compete with foreign rivals.

Many global investors have been reluctant to invest in China's roughly US$12 trillion bond market until now, with international ratings agencies still yet to set up coverage of Chinese corporate debt onshore.

Partly because of poor visibility, Charles Chang, Head of Asia Credit Strategy and Trading Desk Analysts at BNP Paribas says, investing in Chinese domestic bonds is like "looking for treasure in the forest."

"Investing in Chinese domestic bonds is like looking for treasure in the forest."
Charles Chang, Head of Asia Credit Strategy and Trading Desk Analysts at BNP Paribas
"The inclusion of China's domestic bond market in the global indices is essentially like shining a flashlight on that market, which previously is not visible to international investors. So, the importance is much more about visibility and transparency, which encourages participation, and is, at the end of the day, the basic requirement for involvement," he says.

Currently, Emerging Market (EM) investors are parking their assets elsewhere.

"Most EM portfolios, whether it's in London or in the US, have an average allocation to Asia of about 10 to 15 per cent, even though the index they track has Asia at about 20 to 30 per cent, which is to say they have been heavily underweight Asia for quite a long time," Mr Chang says.

"Latin America has been heavily over-weighted, even though Asia has much shorter duration, which means much less interest rate risk. We are in a period with ongoing rate hikes from the fed - there were three last year, and there's probably going to be three or four this year. So for fund managers, the big question is: how do I deal with interest rate risks? By allocating to Asia, you are essentially reducing your interest rate risks," says Mr Chang.

China's inclusion in global bond indices, and the government's continued financial sector reforms, could drive more interest from international investors, which could pave the way for more participation in China's domestic bond market.

"International investors' interest now is based on two factors – more attractive onshore yields, and the rising strategic importance of China's financial markets," says Mr Chang.

However, despite rising inflows from overseas into Chinese bonds last year, foreigners still own less than 2% of the Chinese bond market, with a high proportion of that figure made up of overseas subsidiaries of Chinese institutions such as the nation's top banks and brokerages. This addition is also subject to three operational issues being addressed:

  1. Delivery versus payment (DVP)
  2. Taxation
  3. Block trade allocation
From an access point of view, Julien Kasparian, Head of BNP Paribas Securities Services in Hong Kong, says work continues to improve investor confidence.

"Even with the absence of real-time DVP, growth has been impressive. Work is being completed to meet international needs for DVP in all market access schemes, and to provide improved funding and liquidity solutions. These will be important for investors to gain comfort that the investment risks are manageable and could be a key factor in encouraging indices to add or increase China weightings," says Mr Kasparian.


Key milestones over the past five yearsKey milestones over the past five years



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