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Billions set to flow into Chinese stocks as MSCI lifts weighting

Market reforms open door to greater weighting, but analysts caution on risks

In a sign of China's greater integration into global markets, domestically traded stocks will account for a greater share of MSCI's Emerging Market index.   © Reuters

HONG KONG -- MSCI is boosting the weight of Chinese stocks in its closely tracked Emerging Markets Index, a move that is expected to draw tens of billions of dollars into the country's stock markets and further the drive for financial reforms.

In a sign of China's greater integration into global markets, the U.S. provider of market indexes said on Friday that China's domestically traded stocks would account for 3.3% of its leading Emerging Markets Index by November, against 0.78% currently. Both large- and mid-cap stocks will be included.

The index is a highly regarded benchmark, tracked by global funds accounting for nearly $2 trillion. Yannan Chenye, head of China equity research at Harvest Global Investments, said the changes would "result in significant flows into A-shares" -- as domestically traded stocks are called.

Tracker funds for example, will now be obliged to hold a greater proportion of Chinese shares in their portfolios, to reflect their higher weighting. When combined with China's recent market-opening policies, "we believe it will be a record year for potential inflows," she said. Foreign inflows are expected to jump from $45 billion last year to up to $100 billion, she added.

MSCI last year welcomed more than 230 of China's domestically traded large-cap stocks into its Emerging Markets Index. It was the first year that A-shares were included in the index. This year will see the addition of mid-cap shares.

The successful inclusion of China A-shares "has been a positive experience for international institutional investors and has fostered their appetite to increase further their exposure to the mainland China equity market," said Remy Briand, MSCI managing director.

Briand said the "strong commitment by the Chinese regulators to continue to improve market accessibility, evidenced by, among other things, the significant reduction in trading suspensions in recent months, is another critical factor that has won the support of international institutional investors."

Analysts welcomed the move as a reflection that MSCI and other global index companies were confident that Chinese authorities have demonstrated an ability to push market reforms.

"The increased foreign participation will no doubt help to further shape corporate governance among listed companies, making China's capital markets increasingly globally aligned," said Michael Wu, country executive for greater China at Northern Trust.

Eric Moffett, portfolio manager for T. Rowe Price's Asia Opportunities equity strategy said the move should be a "good incentive" for mainland companies to show greater transparency and to adopt strategies that reflect the interest of shareholders.

"Many companies with good corporate governance practices in the market tend to have a strong foreign institutional investor base," he said. These investors tend to focus on risk-adjusted returns over the long-term rather than absolute return potential in the short-term, he added.

MSCI said it would lift the weighting in three stages by increasing the so-called inclusion factor from 5% to 20%. This is the proportion of a company's free float, at market value, which is included in the index.

It will first lift the inclusion factor of all large-cap shares in its indexes to 10% in May. In August, it will boost the inclusion factor to 15%, followed by the final phase in November, when it will increase to 20% and add mid-cap shares.

That will bring the number of large-cap stocks to 253 and mid-cap shares to 168 in the index. Those figures include 27 shares on the Shenzhen Stock Exchange's ChiNext board, the first time shares on the technology-heavy board will be part of the index.

China's domestic markets have gradually become more accessible to foreign investors in recent years through the Qualified Foreign Institutional Investor program and Stock Connect, which allow global investors to trade stocks in Shanghai and Shenzhen through the Hong Kong Stock Exchange.

Analysts said the index changes would have an impact on share prices, but cautioned there could be risks for investors.

"Emerging market investors are going to end up being significantly underweight in China [and] they will have to increase their holdings of Chinese stocks. It's as simple as that," said Geoffrey Dennis, an independent emerging markets commentator formerly with UBS. "With that big weighting increase, there's going to be big demand."

There is also a risk of volatility in the initial stages, he suggested. "Investors appear to buy on the news that a new sector/country will join the index and then sell on the actual event itself," he said.

Kinger Lau of Goldman Sachs said the higher inclusion factor could "present business and investing dilemmas for asset managers who are currently restrained or discouraged from making direct allocation to the mainland [China] market." Investors are still concerned by issues of corporate governance, market accessibility, regulatory uncertainty and legal obstacles in China, he said.

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