China's global relevance has grown to the point where it can no longer be ignored. The large-scale transformation continues to gain traction and remains a focal point at Sandstone, much as it has for the past several years.
Outlook 2015, China and Asia-Pacific: Coming of Age
"As China emerges as the world's largest economy, growth of 5-7% is what to expect going forward - slower speed, higher quality is the stated objective.... China's financial reforms - currency convertibility, freer flow of capital both inbound and outbound, and greater connectivity between Shanghai and Hong Kong; key catalysts for rising valuation."
Strategists 2Q15, China: Limited Supply, Forced Demand
"As we highlighted at Outlook, China's financial reform agenda is a strong reason to invest. The recent breakout of Chinese and Hong Kong markets is being driven by the same index under-representation that helped the Canadian market post strong returns over the past decade. Chinese under-representation in some of the major international stock indexes has forced money managers to reallocate away from other markets to China, creating forced buying.
Now, with Chinese financial reform taking shape (Shanghai-Hong Kong stock connect, liberalization of the Renminbi and easing foreign ownership restrictions), the same forced demand (benchmarked funds having to increase Chinese weightings) is happening. With Chinese stocks up over 30% so far this year, momentum is significant. Still, given full reforms have yet to be implemented, Chinese stocks likely have more room to run."
Fast-forward to 2018 and China is in the advanced stages of opening their markets and currency.
"China now accounts for 15% of global gross domestic product and 11% of global trade. Additionally, the Shanghai and Shenzhen stock exchanges have grown to an aggregated market cap of $7.5 trillion, second only to the NYSE and Nasdaq. In March 2018, China's bond connect launches - opening up the third largest bond market globally.
A rebalancing may come sooner rather than later as China only represents 3% of the MSCI World index and yet it is the top contributor to global growth. Rebalancing demand alone will create equity market growth as it takes place." ~ OUTLOOK 2018
What is Happening
MSCI, a leading provider of global equity indexes, is a significant influencer on the global investment of both active and passive assets today. In June 2017, MSCI announced that it will include China A-shares into the MSCI Emerging Markets (EM) Index and the MSCI All-Country World Index (ACWI) beginning in June 2018. The China A-shares inclusion marks a breakthrough in obtaining full acceptance into the global economy and further opens Chinese equity markets to foreign investment. Global investors will now have greater access to a market that has traditionally been available primarily to China's mainland citizens.
The Weighting Imbalance
The MSCI ACWI Index is a top global equity benchmark used by institutional Investors all around the world. It was designed to represent the equity performance, from small-cap to large-cap, of 23 developed and 24 emerging markets. Naturally, as the world's largest economy, the US accounts for 52.5% of the ACWI index. As for the world's second largest economy, China's weighting is a negligible 3.67%. To put things into perspective, China's economy is 2x that of Japan, yet Japan's index weighting is 2x larger than China's. Further, while the UK enjoys a larger weighting and France a similar weighting relative to China, the Chinese economy is greater than both countries combined. And while China has experienced significant growth over the past decade, that growth has been largely ignored owing to its under-representation in global equity indexes.
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Inclusion Roadmap
It is important to note that inclusion will not happen overnight. It will be a long, drawn out process starting with two partial inclusions beginning June 1st, 2018, with subsequent inclusions in the following years. Initially, China A-shares will make up only 0.73% of the MSCI EM index. MSCI's plan, however, is to reward improved corporate governance and accessibility with a higher index weighting. MSCI anticipates that full inclusion of A-shares could carry a weighting of ~18% in the MSCI EM index. Together with Chinese companies listed in Hong Kong and in the US, China's total index weighting could potentially grow to 40% at full inclusion.
Why this is Important
While Chinese markets remain relatively inaccessible and initial Index weighting may be small, inclusion in MSCI signals support for China's ambitions of economic globalization. It is a demonstration of international confidence in China's growing credibility and paves the way for exponential money flows into Chinese markets.
The potential impact of the index inclusion has been vastly underestimated. Adding the world's second largest equity market to the largest index provider marks a global structural shift and is a catalyst for considerable asset rebalancing. With ~US$1.6 trillion dollars currently tracking the MSCI EM Index alone, there will be a significant influx of capital that will flow into the Chinese market. Index trackers, and all money managers working from a benchmark, will be forced into inevitable large-scale portfolio repositioning to replicate the newly fashioned indexes. And guess what... the bonds are next.