What debt and equity investors want from China

Global index providers are boosting China in their indices this year. However, China has more work to do to convince investors to stay.

Foreign investors are poised to play a bigger role in China’s equity and bond markets as global index providers gradually include more mainland securities in their benchmarks.

MSCI said in February that it is set to quadruple the weighting of Chinese stocks, known as A-shares, in its indices to 20% by November. This follows FTSE Russell's news that it will phase A-shares into its emerging index starting from June.

Similarly, on the fixed income side, Chinese renminbi-denominated government and policy bank bonds are to be phased in over 20 months into the widely-tracked Bloomberg-Barclays Global Aggregate Bond Index starting April 1. No joke.

To date, overseas portfolio investors have been dramatically underweight China, so benchmark inclusion has the potential to catalyse a mass migration of fresh capital into the world’s second-largest economy. Investment bank Goldman Sachs estimates that at least $70 billion could flow into China-A shares just off the back of MSCI's decision, while HSBC, a major bond house in Greater China, is forecasting average inflows of $7.5 billion per month into Chinese bonds during the inclusion period – so that’s around $150 billion by December 2020.

Index trackers will likely make up a good proportion of the capital on the march but more active managers with deeper pockets will probably also wade in to take advantage of the uplift in valuations.

The historic move by leading index compilers is in response to the various reforms enacted by Beijing to improve investor sentiment, promote China’s fast-growing new economy and attract more institutional investors onshore. It’s been a long time coming too – after all, it is some 40 years since Deng Xiaoping first enacted reforms designed to better integrate China into the world economy.

Among the more recent landmark reforms is last year’s announcement that foreign firms can own 100% of their onshore joint ventures as well as the imminent launch of a Nasdaq-style tech board in Shanghai.

China has drafted a plan to combine the Qualified Foreign Institutional Investor (QFII) and its renminbi-denominated sibling, RQFII. Also, the QFII quota was doubled to $300 billion in January.  

But there’s still much more to be done if China is to reach anywhere near its full potential as a destination for investor capital.

China’s lack of clear and transparent rules, especially on the repatriation and tax treatment of capital, can only come under greater scrutiny as more foreign investors enter its markets. 

“The need for disclosure and governance standards to be brought on par with acceptable international standards will only gather pace,” said Fullerton Fund Management in a research note.

China should also speed up the convergence of all the myriad capital access schemes.

Foreign investment managers that have already invested in China want to be able to consolidate their positions across the different schemes to reduce duplication, achieve operational and cost efficiency and optimise returns for their investors, according to the Asia Securities Industry and Financial Markets Association (Asifma).

Foreign investors also don’t think it is too much to ask for trading and settlement processes to be better harmonised with international standards for both debt and equities, as this would cut out the need for work-around solutions. Many markets around the world have converged or are moving to a Delivery-versus-Payment T+2 settlement cycle, hint hint.

And when it comes to initial public offerings (IPOs), investors want a more market-orientated approach for accessing shares instead of the current lottery mechanism. Asifma is pushing for an IPO process that includes book building to set the issue price and allocations, which would help with price discovery, improve the quality of the shareholder base and stabilise the share prices of newly listed companies.

In bonds, restrictions on futures are a common gripe.

“The next big step is to create a functioning fixed income futures market,” said Quentin Fitzsimmons, a bond portfolio manager at T. Rowe Price that manages over $10 billion assets in global aggregate bond strategies.

But at least there’s movement on the shares front, with the Hong Kong stock exchange poised to introduce futures contracts based on the MSCI China A Index from November, in timing with the MSCI’s adjustments. 

Many overseas investors are leery of the policy risks associated with a readjustment of the trade relationship between the US and China, so China’s upgraded index credentials represent a ray of sunshine for investors in the celestial kingdom. It’s also positive for China, which stands to benefit as foreign capital boosts liquidity for domestic investors, reduces market volatility and underpins demand for the currency.

However, Beijing would do well to remember that if investors don’t like what they see, they can quickly reverse course.

They can also continue to stay out of China, as some seemingly look set to for the foreseeable future. After all, why else would Bloomberg create ex-China versions of its Global Aggregate index?

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