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The size and scale of China’s domestic marketplace has become one the nation’s greatest economic achievements. From the middle-class explosion to the sweeping impact of digital transformation throughout its population and industries, China—and the global economy—are entering a new era of investment opportunities. There is money to be made by investing in China but opening up the country’s heavily regulated domestic assets to foreign investors entails a learning curve on both sides. Perspective: China vs. Growth Economies The Mercer report The Inclusion of China A-Shares in MSCI Indices: Implications for Asset Managers and Investors, explains why opening China’s domestic market to the global economy has created a wave of excitement throughout the international investment community and marketplace. This enthusiasm is being carefully managed by the measured strategy China and the MSCI are implementing while forging a framework for future growth. The initial phase only weighted 226 stocks at a mere 5 percent of their market cap, demonstrating that this new era will be defined by an incremental, long-term mindset. This cautious approach may be welcome news to competing growth economies in the region. Despite the conservative rollout of Chinese A-shares (domestic assets) to the international marketplace, inclusion in the MSCI Index will profoundly impact the global economic landscape, especially with regard to the influence of emerging economies. Take, for instance, what the MSCI Index will look like with the inclusion of 5 percent of Chinese A-shares, and then at 100 percent inclusion. Growth economies such as India, Taiwan and South Korea may be negatively impacted by the inclusion of domestic China in global indexes, especially if investors shift their focus from growth markets to new opportunities in Chinese A-shares. (Source: MSCI) Change is inherently fraught with breakthroughs, obstacles and the anxiety of the unknown. Though no one can 100 percent accurately predict the future, let’s examine the opportunities and challenges of China’s new status in the global economy, and what it means to equity investors. Opportunities from Inclusion in MSCI: 1.      Market Size: The Chinese domestic market is large, comprising more than 3,000 stocks, and is the most liquid in the world. Since the beginning of 2017, the Shanghai and Shenzhen Stock Exchanges have experienced higher aggregate daily trading volume than the New York and NASDAQ Stock Exchanges combined.  2.     Diversity: The Chinese domestic market entails a cross-section of companies that represent a broad number of industries, and it is much more diversified at the sector level than the China shares listed in the Hong Kong Stock Exchange (which is highly concentrated in IT and financials). 3.     Uniqueness: Historically, China’s A-share market has displayed a low correlation with other equity markets, marking an era of new and unexplored opportunities to create value. 4.     Limited Foreign Ownership: With domestic Chinese retail investors comprising more than 75 percent of the free-float market cap—the number of outstanding shares available to the general public—there is a lack of informed institutional owners in the market. The unprecedented nature of the situation can create inefficiencies, but also yield an environment that can be conducive to investors willing to explore new opportunities. Challenges from Inclusion in MSCI: 1.      Volatility: Although the market is large and liquid, it is volatile and has experienced periods when liquidity has fallen dramatically in short periods of time. However, China has taken steps to mitigate volatility, including the formation of a “national team” to help stabilize the market by purchasing A-shares in times of market stress. 2.     Concentration: There is concern regarding the composition of benchmarks when China A-shares are included in indices at their full weight. Global emerging market benchmarks are relatively diversified at present, but they will become increasingly dominated by China following the full inclusion of the China A-share market. However, to address this issue, many innovative organizations are recruiting analysts and portfolio managers experienced in the region—or are nurturing in-house/hybrid solutions to explore standalone investments and other strategies. 3.     Global Uncertainty: Trade tensions between the US and China, and other geopolitical concerns have made some investors skittish about opportunities in China’s domestic marketplace. As markets seek stability over chaos, an unknown future and emerging investment realities and mechanisms will have some organizations choosing to stay on the sidelines. This, however, means more potential opportunities for investors with the portfolios and risk tolerance to explore new opportunities. To learn more about how the inclusion of China’s A-shares in MSCI Indices will impact the global marketplace and create new investment opportunities for your organization, visit Mercer Wealth and Investments (or Mercer Wealth and Investments – China).

Gareth Anderson | 21 Mar 2019
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The globalization of the world’s economy is taking a giant step forward. MSCI is opening the door to the world’s second-largest stock market – China. This development will create unprecedented opportunities and challenges as China and the international investment community nurture this new, remarkable relationship. The domestic Chinese stock exchange (Shanghai and Shenzhen) offers global institutional investors and hedge funds previously unexplored pathways to build value and generate earnings. The Path Towards Global Credibility     China’s increasing prominence in the global market underscores the evolution of longstanding policies and cautious perceptions regarding the role of outside investors. The Mercer report The Inclusion of China A-Shares In MSCI Indices: Implications for Asset Managers and Investors, chronicles the journey that China and the international investing community have made together to reach this historic agreement, and what to expect from a new era of growth and collaboration. Before the MSCI breakthrough, the primary mechanisms that granted foreign investors entrance to China’s domestic market were the Qualified Foreign Institutional Investor (QFII) and Renminbi Qualified Institutional Investor (RQFII) schemes—both of which were heavily regulated by rules and regulations limiting the types and sizes of organizations allowed to apply for a quota and their ability to repatriate capital. Chinese authorities, however, have made opening the mainland equity market a key priority. Executing this innovative strategy, however, required a disciplined and calculated approach to implementing change. China began by creating mechanisms to accommodate foreign investors. In December 2016, the Shenzhen-Hong Kong Stock Connect program was launched, providing foreign investors access to companies listed on the Shenzhen Stock Exchange. This forward-thinking initiative opened up the path to global influence and participation, with both China and the international investment community working together. The Power of Patience & Compromise   Inclusion in the MSCI Index started with building trust and goodwill through shared interests and compromises made by both sides. The Shanghai/Shenzhen-Hong Kong Stock Connect programs—together referred to as “Stock Connect”—provided an additional quota to foreign investors and loosened burdensome restrictions. The relaxation of daily trading limits, continued progress on trading suspensions and further easing of regulations—in addition to the creation of new index-linked investment vehicles—led to acceptance by MSCI. China has illustrated its willingness to work collaboratively with the MSCI and the global investing community. In return, the MSCI made several concessions to facilitate the inclusion of the China A-share market. Rather than slowing the process, MSCI offered a more aggressive and streamlined approach to inclusion. The MSCI’s lean but efficient strategy limits stock and country ratings and only allows international investors predetermined exposure in a particular market. These developments are just the first steps to a long journey. The agreement also serves as a powerful symbol for a promising future of growth and mutual prosperity. The weight of China A-shares in the broad market indices will have to increase over time. In perhaps 5-10 years, Chinese A-shares can evolve from partial to full inclusion, much like the Taiwanese and South Korean markets did beginning in the 1990s. The Way Forward for Investors   The MSCI acknowledges the volatility endemic to entering such a massive and complex economy. Managing expectations is critical to advancing the initiative. The first phase weighted only 226 stocks at 2.5 percent of their market cap, and the next phase increased the number of stocks by 10 and adds 2.5 percent—at a total of 5 percent of market capitalization.1 The MSCI is clearly taking a restrained approach to promoting growth and inclusion. Though the China A-share market has a number of appealing features, for investors with relatively small or straightforward equity portfolios, it would be quite reasonable to adopt a wait-and-see approach to the emergence of China. Other investors may choose to be more proactive. Investors with a material portion of their wealth invested in emerging market equities, and who seek to evolve their portfolio over time, should consider how they can incorporate the expanding Chinese opportunity within their broader equity allocation. A standalone allocation allows a higher weighting (than allocations dictated by the benchmark) with broader and deeper exposure to the market-enhancing both the return and diversification potential. However, investors must simultaneously address important risks and governance questions, especially considering the unprecedented nature of this developing scenario. To learn more about how the inclusion of China’s A-shares in MSCI Indices will impact the global marketplace and create new investment opportunities for your organization, visit Mercer Wealth and Investments (or Mercer Wealth and Investments – China).   1Pisani, Bob. “Here's Why You Will Own More China Stocks in the near Future.” CNBC, CNBC, 31 Aug. 2018, www.cnbc.com/2018/08/31/msci-adds-more-mainland-china-stocks-a-shares-to-its-indexes.html.

Gareth Anderson | 21 Feb 2019
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