Having been denied admittance to the MSCI Emerging Markets Index for three years straight, it was confirmed in June 2017 that Chinese A-Shares would finally be incorporated into the benchmark, enabling global passive investors to gain exposure to an equity market second only in size to the US. More good news followed nine months later when Bloomberg Barclays gave the nod to Chinese bonds being allowed into its Global Aggregate Index, a huge boost for the local debt market, estimated to be in the region of $9-$11 trillion.
“When you look at the size of the markets, it is completely logical for the major index firms to include them. In some ways, it could be seen to be a surprise that it had not happened earlier. In reality, it is the internationalisation of the Chinese markets and the improved access routes for offshore investors that have created options which are more aligned with global standards allowing index managers to take these decisions,” says Gary O’Brien, regional head of custody product, APAC, at BNP Paribas Securities Services.
MSCI takes stock
Chinese regulators have introduced a series of equity market reforms, expanding the number of gateways for foreigners to buy domestic securities beyond QFII (Qualified Foreign Institutional Investor) and RQFII (Renminbi [RMB] Qualified Foreign Institutional Investor) schemes. Stock Connect created a linkage between the exchanges in Hong Kong, Shanghai and Shenzhen, giving investors easier access to each other’s respective capital markets, with more than 2000 equities now eligible for trading.
Regulators recently announced an increase in the daily trading quotas on Stock Connect, and it is expected exchange traded funds (ETFs) and primary issuances will be added to the impending “Connect” adaptations within the next 18 to 24 months. Furthermore, according to reports, the UK’s London Stock Exchange is planning to go live with a London-Shanghai Stock Connect programme this year, despite concerns over time-zone differences, divergent settlement cycles, the use of RMB in settlements and Chinese short-selling restrictions.
These reforms have been a driving factor behind MSCI’s inclusion of A-Shares, as has the government’s loosening of various restrictions ushered in following the equity market volatility in 2015 and pressure on the RMB. PBOC, for example, recently notified financial institutions that matching outflows with inflows when processing cross-border RMB payments was no longer needed, while the frequency of A-Share trading suspensions has fallen too, although it still remains high relative to other markets.
Bond market reform takes shape
The size of China’s bond market – eclipsed only by the US and Japan – has not translated into strong investor flows, with foreign ownership of outstanding government debt accounting for just 2.4% of the total, according to a Standard Chartered white paper, versus 38% in India, the country’s largest regional competitor. The government has attempted to redress this anomaly, by broadening foreign investor access beyond the conventional QFII and RQFII routes by introducing CIBM Direct and Bond Connect.
Both CIBM Direct and Bond Connect let investors trade Chinese bonds without being subject to quotas in contrast to QFII and RQFII. However, CIBM Direct is fully onshore and requires investors to appoint a local custodian, whereas Bond Connect is offshore, meaning institutions can work with Hong Kong-based providers. “Market reforms played a big part in persuading Bloomberg Barclays to include Chinese bonds on its index,” said Florence Lee, head of China sales and business development, EMEA, HSBC Securities Services.
Bracing for flows
MSCI said it would begin to incorporate 234 China A Large Cap stocks from June 2018 into its Emerging Markets Index, accounting for 0.78% of the flagship index, and approximately 5% of the overall number of A-Shares in existence. This threshold, said MSCI, took into account the continued ownership limits in China, adding that further reforms needed to be enacted before full inclusion could be justified.
“MSCI has made it clear that the 0.78% weighting is only an initial weighting, and that a full weighting will materialise once China makes improvements to its market access channels, among other reforms,” highlighted Lee. Despite only having a partial inclusion, experts are predicting initial flows – driven by passive managers – into A-Shares could reach anywhere between $15 billion and $17.5 billion. O’Brien of BNP Paribas says he has seen interest from passive and active managers planning to increase their A-Share exposures.
Margaret Harwood-Jones, global head of securities services, transaction banking at Standard Chartered, agrees. “One of the most commonly asked questions we are fielding from institutions is ‘how quickly can we get authorised in China?’. Since index inclusion was announced, there has been a very noticeable increase in the number of organisations setting up Special Segregated Accounts (SPSA) to trade under the Connect programme ahead of the first index rebalancing date,” she says.
The scale of full MSCI inclusion – assuming it happens – should not be underestimated. Full inclusion would not only result in A Shares accounting for 20% of the MSCI Emerging Markets Index, but that total would be on top of the existing 27% offshore China share weighting. Flows could therefore multiply by many times over with some industry experts predicting they may even exceed $500 billion.
Bloomberg Barclays has also taken a relatively conservative approach towards China – and like MSCI – has opted against immediate full inclusion. Commencing in March 2019, Bloomberg Barclays will incrementally begin incorporating RMB denominated bonds, with 10% being added to the benchmark every month until September 2020, at which point there will be full inclusion. According to Standard Chartered, full inclusion could result in $286 billion of passive flows moving into China.
Can China handle it?
Passive flows will generate enormous opportunities within China. Not only will it create liquidity benefits, but it could offset some of the outflows the country has experienced as a result of the equity market volatility and may even help the country weather the adverse consequences of any potential trade war with the US. But could these large flows present problems for China’s market infrastructure?
“The market infrastructure in China and Hong Kong is very strong, and we believe the systems they are using are well-placed to handle the increased transactional volumes. Standard Chartered, for example, has worked very closely with Hong Kong Exchanges and Clearing (HKEX) to ensure the operating model can handle the flows,” says Harwood-Jones.
Others broadly concurred, although conceded there could be challenges. “I am unconcerned about whether the onshore equity market will be able to handle the flows coming in off the back of the MSCI upgrade because the market is so big relative to the size of the inflows from international investors,” says Lee. “The real test will be whether Stock Connect’s infrastructure in Hong Kong can cope with the trading volumes from the increasing demand and if there is sufficient offshore RMB liquidity to settle all of the transactions.”
Nonetheless, there are some operational issues with Bond Connect, which need mending prior to any large-scale passive inflows, a point acknowledged by Bloomberg Barclays. China Central Depository & Clearing Corporation cannot settle transactions through real DVP (delivery versus payment) exposing investors to counterparty risk, an impediment Lee said was obstructing regulated funds like UCITS from entering China’s bond market.
Other problems have also been flagged. “Bloomberg Barclays has said that improvements are needed to enable block trading, and it has asked for more clarity to be given around taxation,” explains Lee. At present, there are tax exemptions for investors – namely a 0% levy on government bonds regardless of the access channel, but the authorities have yet to provide information about the tax treatment of other debt instruments.
A Standard Chartered report acknowledged that while some investors are comfortable investing in China despite the ongoing tax uncertainty, others were putting their plans on hold until assurances are provided by the authorities. “The three outstanding issues around Bond Connect – namely the lack of real DVP, taxation uncertainties and block trading limitations – are being addressed from what we understand. We are confident a resolution around block trading, for example, will be found by the end of Q2,” says Harwood-Jones.
Fortunately, China does have time to implement these market reforms. “Chinese bonds will start to be incorporated onto Bloomberg Barclays from April 2019, so the government has just under one year to implement the various changes requested,” says Lee. Given the pace at which China has instituted reforms of late, remedying these problems should not be too onerous for a country with such large global ambitions.