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Business Insight

Modest A-shares move marks the start of something big

Timing of China-quoted companies' inclusion in MSCI index is auspicious

China's equities now officially enter the global market. (Photo by Akira Kodaka)

This has been a good time for peddlers of Asian emerging market shares, particularly those who deal in China stocks.

June 1 marked the day that China's domestic A-share markets were officially included in the MSCI Emerging Markets Index, which many investors in the sector use to measure their performance. On the eve of inclusion, net orders for Chinese stocks routed through Hong Kong doubled compared to average daily volume in May, setting a record for a single month.

To be sure, the significance of inclusion is in some ways symbolic; the initial weighting is a mere 0.4% of the index, rising to 0.8% by the end of the year. Never mind. In the last three months, investors have poured $15 billion into Shanghai and Shenzhen, while passive investors who aspire only to match benchmarks are expected to put in another $3-4 billion to reflect the change. Morgan Stanley is suggesting to investors that they embrace a 5% weighting in China by the end of the year -- far more than the modest weighting of China in the index.

This enthusiasm reflects a coming of age that is more than symbolic. For the past few years, the compilers of the MSCI have rejected the inclusion of A-shares -- stock in mainland Chinese companies quoted in yuan in Shanghai and Shenzhen -- because of concerns about transparency, regulatory interference and fraud. There have also been questions about Chinese restrictions on capital flows.

These concerns have now largely (though not entirely) waned. "Under tighter regulatory rules, trading suspensions -- a serious concern for international investors -- have declined in absolute numbers and as a percentage of the total number of A-shares," analysts at UBS said.

"This is a very important step in China's capital account opening-up process, and a symbolic event of the capital market connectivity between China and the world," said Haibin Zhu, JPMorgan's chief China economist and equity strategist. "China's equity market now officially enters the global space."

Zhu added that the inclusion of Chinese equities in the MSCI was "the second very important milestone" after the 2016 addition of the yuan to the basket of currencies included in the International Monetary Fund's special drawing rights, which acts a backstop international currency.

The timing is auspicious. The China story has never looked better from the point of view of economists and investors. It is a far cry from the summer of 2015, when the market was in meltdown, capital outflows threatened the stability of the yuan, and regulators ordered local brokers to support the market, later accusing many of insider trading. The growth of credit in both the banking and shadow banking markets was so rapid and inefficient that many analysts in China and elsewhere forecast another global financial crisis -- this time made in China.

Today, by contrast, the rate of increase in debt has decelerated, and economic growth is strong, at 6.9% for 2017. A bit of inflation has reduced the burden of debt repayment, while cuts in the production capacity of inefficient state enterprises have restored profitability in sectors such as aluminum, coal and steel. China created more than 10 million jobs last year, while wages rose 9% in real terms. The biggest risk on the horizon is the prospect of trade protectionism in the U.S. Other than that, macroeconomic conditions remain benign.

There are many reasons to justify the bullish stance of brokerages such as Morgan Stanley. The A-share market is attractive for themes that reflect China's growing prosperity. These include healthcare and high-end manufacturing, and plays on domestic consumption such as Kweichow Moutai, a maker of the fiery drink baijiu that was a victim of Chinese President Xi Jinping's anti-corruption campaign (which put an end to elaborate banquets) but has since been on a tear.

Many such companies are not quoted in Hong Kong or other exchanges outside the Chinese mainland, including video surveillance vendor Hangzhou HikVision Digital Technology, home appliance supplier Midea Group, hydroelectric power generator China Yangtze Power, medicine manufacturer Jiangsu Hengrui Medicine, and joint-stock banks such as Shanghai Pudong Development Bank.

In addition, corporate earnings growth has remained strong, up 19% in 2017 and 16% year-on-year in the first quarter of 2018, according to data from UBS. Earnings are expected to remain robust, compared to Japan or to the rest of Asia, according to Morgan Stanley's equity strategist Jonathan Garner. In addition, the A-share market today is relatively cheap in comparison to its own past performance and to global peers.

Inclusion in the MSCI index may change the Chinese markets in unexpected ways. One of the factors that has drawn professional investors in recent years is the dominant role played by retail investors, who buy and sell on the latest rumors. That makes it relatively easy for more disciplined investors to succeed, using computer algorithms and artificial intelligence that can arbitrage even the smallest price aberrations.

That may change as Beijing improves foreign access to China's domestic markets, helping to improve the efficiency of the market and dampen price volatility. The Chinese Securities Regulatory Commission increased the daily quota for investment into China through Hong Kong by a factor of four recently, and has plans to increase the level of direct foreign flows as well.

The Chinese market is still young, but it is maturing quickly.

Henny Sender is the Financial Times' chief correspondent for international finance, based in Hong Kong, and contributes occasional columns to the Nikkei Asian Review. She has extensive experience of covering international finance.

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