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June 2017

Enter the Dragon

MSCI's decision to include Chinese A shares in its main indices has the potential to transform global capital markets

For now, the MSCI’s decision to include mainland China shares in its emerging market index is a minor tremor in the investment landscape. The bigger seismic event could come later.  
Chinese domestic equities – A shares – will account for just over 0.7 per cent of the MSCI Emerging Market stock index when they enter the benchmark in the middle of next year. In the near term, that doesn’t add up to a dramatic shift in global equity portfolios.
But over the long run, it could be that the decision proves as transformative for the international capital markets as China’s inclusion in the World Trade Organization was for the world economy in 2001. 
In endorsing Beijing’s efforts to open up China’s securities to foreign investors, the MSCI could facilitate the country’s climb to the top tier of global financial markets in a number of ways. 
For one thing, market reforms in the world’s second largest economy can now be expected to gather pace. The recent launch of a direct trading link between Shenzhen and Hong Kong exchanges and a reduction in trading suspensions are the beginning of what we believe will be a much deeper financial and regulatory overhaul.
What is more, the emergence of an open and efficient stock market could help put the Chinese economy on a more sustainable footing by encouraging domestic firms to use equity as a source of finance rather than debt. As things stand, corporate borrowing amounts to an eye-watering 156 per cent of GDP in China. This ought to give international investors even greater confidence in Chinese securities.
Anomalous: cHina's position in global financial market at odds with economic heft
China MSCI

Source: IMF, Bloomberg, MSCI. Data as of 22.06.2017 

All in all, the MSCI’s decision leaves us more convinced that Chinese stocks will become major international investments in as little as five years. 

There are, of course, no guarantees when it comes to reform. China’s change programme is ambitious yet complex and unlikely to progress smoothly. Currently, around two thirds of Chinese listed companies are part owned by the state in some shape or form while governance standards do not compare favourably with those of developed world. At the same time, authorities must shake off the urge to intervene in markets when investor sentiment turns. Their past attempts to stabilise market conditions with share purchases and trading curbs proved counterproductive. 

Nevertheless, we believe China’s progress towards internationalisation is too powerful to stop. By the end of the next decade, if not before, renminbi securities will become a major feature in investors’ portfolios worldwide, in much the same way euros and dollars are core investments today. Chinese stocks account for just 3 per cent of global equity portfolios even though their combined market cap of USD9 trillion is second only to that of the US, which accounts for over 50 per cent of the MSCI World Index.

The flip-side to this re-allocation process is a relative decline in the status of US financial assets and a consequent round of pressure on US Treasuries. Second-tier reserve currencies such as the Japanese yen and sterling are likely to see their global status decline, putting pressure on related assets like Japanese government bonds.