The prospect that China's A-shares could be included in major investment benchmarks is another part of the jigsaw of growing international access to its markets.

In an event that could prompt large investment flows, benchmark provider Morgan Stanley Capital International, or MSCI, is due to decide as soon as tomorrow whether to include mainland China’s A-shares equities in MSCI’s world and emerging market indices.

If MSCI decides that shares listed in the world’s second-largest economy are fit for inclusion, it could create a virtuous circle of rising liquidity in such shares, because a far wider pool of international investors, such as pension and life funds, among others, will be able to hold them under their mandates.

Such a move will represent a major step for a country that has already sought to widen foreign access to its capital and financial markets through developments such as the Hong Kong/Shanghai Stock Connect link and the broadening of foreign investor quotas.

And while the renminbi currency is not yet a fully floating one, that day is surely approaching. Another closely-watched decision will be whether, and in what ways, the International Monetary Fund decides to include the Chinese currency in the basket of currencies that composes the Special Drawing Right. (SDRs are supplementary foreign exchange reserve assets defined and maintained by the IMF and have come into the spotlight amid periods of financial stress, and worries about the strength of the dollar.)

The prospect of such a move prompted Jian Shi Cortesi, investment manager at GAM, the Zurich-listed investment house, to comment.

“Increasing the allocation to Chinese equities in the MSCI world and emerging market indices could markedly boost flow levels for a number of reasons. Most international investors are not currently buying Chinese A-shares. Sourcing information is challenging for many investors due to the language barrier, and many are not prepared to buy A-shares as China is not yet included in the index,” she said.

A few days ago, index provider FTSE Russell announced that it will launch two transitional indexes that include China A-shares, a move that will, wealth managers say, affect Chinese market inflows significantly. With MSCI’s decision on including A-shares due on 9 June, demand for these stocks could cause liquidity issues, Cortesi said.

Separately, US investment management giant Vanguard, overseeing more than $3.3 trillion of assets, has announced it will include Chinese mainland A-shares in one of its funds, the Vanguard Emerging Markets Stock Index Fund, and its exchange traded fund share class.

Big move
GAM’s Cortesi said: “All China related ETFs will have to start buying these Chinese stocks when they are included in the benchmarks. Approximately 25 per cent of the MSCI Emerging Markets Index is currently allocated to China, but with the addition of Chinese A-shares and US ADRs – Chinese equities listed on US exchanges – this could increase to more than 40 per cent of the index.
 
“The timing of the inclusion is not certain. There could be a series of gradual weighting increases over a few years; this seems sensible given there needs to be enough liquidity in the market for the buy side to purchase underlying A-shares. However, currently China’s QFII schemes and Stock Connect programme have quotas and can digest only a certain amount of flows, and if all index providers announce an inclusion in short proximity, the potential for market dislocation could be quite large. As all ETFs have to purchase the underlying shares on the same day that an index provider’s change to its allocation comes into effect, flows into US-listed Chinese companies and Chinese A-shares could be very significant,” she added.

“US-listed ADRs from China will be added into the existing MSCI China Index, which currently tracks Hong Kong listed Chinese companies, after they have been evaluated during the index review in November 2015. This will result in significant inflows into ADRs, but outflows from current index constituents,” Cortesi added.

Bubble trouble or growing pains?
Regardless of what will be the medium-term effect of including A-shares in global benchmarks such as from MSCI, recent price movements in equity markets in China have been dramatic, prompting some concerns.

“An investor would have needed to buy the Euro Stoxx 50 back in late 1996 to have equaled the price appreciation of Shenzhen’s rally in the past five months. In fact, the combined wealth created this year by the Shanghai and Shenzhen markets could purchase all the property in London twice,” James Purcell, global investment office, UBS Wealth Management CIO, and Hyde Chen, equity analyst, UBS WM CIO, said in a recent note.

“Doubling your money normally involves visiting a roulette table and picking a colour correctly. Or making a good-hearted wager with a friend. This year these methods have been joined by investing in China’s Shenzhen composite equity market, which has delivered a stunning 114 per cent price appreciation. Let’s put the Chinese rally into context,” the UBS managers said.

“Few would argue that the rally has been fundamentally driven. Earnings estimates have actually fallen and the Chinese economy continues to deteriorate. Year-over-year fixed asset investment growth is the slowest it’s been since 2000. Industrial production is increasing at a much reduced pace, one last seen in 2008. And retail sales growth is limping along at 2006 levels,” they continued.

UBS notes that mainland China-listed equities trade at an average premium of 30 per cent, with some as high as 200 per cent, a dislocation that may fade in time if authorities remove capital barriers.

In any event, whatever happens this week at MSCI, China’s capital and equity markets look set to continue becoming more prominent in the portfolio holdings of global investors.