By Minny Siu, Richard Mazzochi, David Mu, Jessie Ng and Marina Lauer King & Wood Mallesons’ Hong Kong office.
Today, MSCI Inc. (“MSCI”) announced the results of its 2017 Annual Market Classification Review, including its decision on its proposed inclusion of China A-shares in its MSCI Emerging Markets Index and other major global indexes.
This is yet another important breakthrough for China’s equity market and for global investors. Investment funds and financial products tracking these indexes globally will now be mandated to invest in the China A-shares market from June 2018.
To assist your assessment and understanding of MSCI’s inclusion of China A-shares, we are publishing a series of articles relating to the legal issues concerning the China A-shares market and the existing investment channels to access this market.
The background to MSCI’s decision, MSCI’s revised proposal and consultation, as well as key potential issues for global investors considering investment in China A-shares through the Shanghai-Hong Kong Stock Connect and Shenzhen-Hong Kong Stock Connect programs (the “Stock Connects”), are described in our first article in this series.
In this second article, we outline the final implementation decision, the reasons behind MSCI’s decision to include China A-shares in its major global indexes, the impact the decision is expected to have and the next steps for inclusion.
This morning’s decision
MSCI’s decision on the classification of the China A-shares market is based on its Global Investable Markets Indexes Methodology, which includes 18 measures across its market accessibility criteria.
Although the China A-shares market remains classified as “Standalone”, MSCI has been reviewing this market against the MSCI market accessibility criteria and consulting with global investors since June 2013.
MSCI’s decision to include China A-shares in its major indexes was based on its proposal as revised earlier this year, with the following further changes announced this morning:
- following investors’ feedback, Large Cap China A-shares in companies which have H-share constituents already included in the MSCI China Index will be included (notwithstanding that in its consultation, MSCI had proposed that these stocks should be excluded to reduce overlap exposures with marginal weight) — this increases the total number of stocks to 222 with the estimated weighting of China A-shares to be 0.73% in the MSCI Emerging Markets Index and 0.1% in the MSCI All Countries World Index;
- China A-Shares that are suspended during index review will not be eligible for inclusion (this is in addition to the exclusion of stocks which have been suspended for more than 50 days in the past 12 months, and removal of index constituents which have been suspended for more than 50 days); and
- MSCI will continue to consult on its proposal to postpone implementation of index changes linked to corporate events and the MSCI quarterly index review to the next day if such adjustment event falls on a day on which the Stock Connect Schemes are not open or are closed due to reaching a daily limit.
Additionally, the inclusion is proposed to be completed in two stages: the first stage will include A-shares with a 2.5% inclusion factor following the MSCI Semi-Annual Index Review in May 2018 and the second stage will increase the inclusion factor to 5% following the MSCI Quarterly Index Review in August 2018.
This two-stage inclusion process is due to the daily limits on the Stock Connects and is intended to reduce the risk that the daily limits will be reached when the inclusion initially takes effect. MSCI has stated it may revise this two-stage inclusion process if the daily limits are removed or significantly increased prior to these review dates.
The remaining features of the revised proposal, including that only stocks available via the Stock Connects will be included, will be implemented as outlined in our first article.
Reasons behind MSCI’s decision
1. Flexibility of the Stock Connects
The development and expansion of the Stock Connects, which allow global investors to access China A-shares without applying to become part of or being subject to the requirements of the QFII or RQFII access channels, were crucial to MSCI’s decision. As MSCI described in its 2017 Global Market Accessibility Review released this morning:
“The expansion of Stock Connect has been a game changer for the market opening of China A shares. International institutional investors welcomed the expansion of Stock Connect and viewed it as a more flexible access framework compared to the current Qualified Foreign Institutional Investors (QFIIs) and Renminbi Qualified Foreign Institutional Investors (RQFIIs) regimes.”
As discussed in our first article, MSCI’s revised proposal earlier this year limited the stocks to be included to those which are available to global investors through the Stock Connects and made key adaptations to the proposal to reduce replication risks for funds tracking MSCI’s indexes by investing through the Stock Connects alone. It was widely expected that these revisions could lead to a positive decision on inclusion this year.
2. Reduced trading suspensions
Although the frequency and extent of voluntary trading suspensions in the China A-shares market remain the highest in the world, their significant decline was a vital consideration in MSCI’s decision.
Furthermore, as outlined in our first article, MSCI’s revised proposal earlier this year excluded stocks which are suspended for more than 50 days in the past 12 months, in addition to excluding any stocks suspended for more than 50 days in line with its previous proposal. In its announcement this morning, MSCI has also decided to exclude any stocks which are suspended at the time of index review. These changes in the proposal drastically reduce the extent to which trading suspension practices affect the China A-shares market for the purposes of MSCI’s major global indexes.
3. Loosening of pre-approval requirements
MSCI has been in discussions with the Shanghai and Shenzhen stock exchanges regarding their pre-approval requirements for structured products issued in China or overseas which rely on indexes that include A-shares.
These pre-approvals apply to financial institutions offering both new or existing financial products on any stock exchange internationally, where those financial products are linked to an index that includes China A-shares.
In its announcement this morning, MSCI referred to “the loosening by the local Chinese stock exchanges of pre-approval requirements that can restrict the creation of index-linked investment vehicles globally” as a fundamental consideration in its decision.
Expected impact of the decision
The decision mandates passive investors tracking the index to invest in the China A-shares market as from June 2018, with an estimated US$1.5 trillion in assets tracking the MSCI Emerging Markets Index alone.
However, the proposed two-stage inclusion process and the reduced number of stocks to be included, which it is estimated will comprise 0.73% of the MSCI Emerging Markets Index on inclusion, will ensure the short-term impact of the proposal on China’s US$7 trillion equity market is gradual. Overseas-listed Chinese stocks will continue to significantly outweigh China A-shares in the major global indexes.
Over the long-term, this decision is a significant mark of the liberalisation of the China A-shares market for investors globally and an important advance in the integration of Chinese equity markets with global capital markets. The decision will also see RMB playing an ever-increasing role on the global stage and the further development of index futures and currency derivatives as a consequence of increased market exposure.
For investors, this represents opportunities to diversify and to access China’s domestic equity market, including increased exposure to its consumer industries and tremendous economic growth.
Finally, the decision may have a significant impact on the Stock Connects infrastructure. HKEx has indicated that, if MSCI decides to include A-Shares, it will implement further enhancements including:
- requesting China side to remove the daily quota limit or to further increase the daily quota for Northbound; and
- considering acceptance of HKD/USD on T+0 to address the liquidity pressure on CNH available outside China for A-Share investments.
What’s next?
In the lead up to inclusion in June 2018, MSCI will launch a range of provisional indexes this year and conduct a series of consultations. As foreshadowed in our first article, the main outstanding issue for consultation is whether MSCI’s index review methodology should be amended to allow for the postponement of the implementation of index changes affecting China A-shares in circumstances where the Stock Connects are closed due to market holidays or daily limits. MSCI will also consult on the transition of its existing China A indexes.
MSCI will consider further inclusion of China A-shares in line with developments in the China A-shares market as against its market accessibility criteria, and subject to further consultation with global investors. This may be in terms of either or both an increased inclusion factor or the inclusion of Mid Cap China A-shares.
MSCI has pointed in particular to the removal or relaxation of the daily limits on Stock Connects, decreases in the frequency and extent of voluntary trading suspension practices, and further deregulation of the financial product pre-approval requirements, as being key areas where developments will be carefully observed.
We are advising clients on a range of issues of concern to investors and market operators regarding China A-shares including market access, the Stock Connects and (R)QFII schemes.
In response to this significant development, if you would like any further information, please let us know.
For further detail on the historical evolution of the China A-shares market and the launch of the Shanghai-Hong Kong Stock Connect, please see our KWM Connect publication. Please click “continue reading” to the download page of this PDF.