China’s domestic equities will join MSCI Inc.’s benchmark indexes after three failed attempts, a landmark step in the nation’s integration with the global financial system.

The decision, announced by the New York-based index compiler on Tuesday, will give China’s $6.9 trillion stock market a bigger role in everything from exchange-traded funds to 401(k) retirement plans. It also advances President Xi Jinping’s ambitions to make the yuan a global currency.

While China’s locally-traded A shares will comprise just 0.7 percent of MSCI’s global emerging-markets gauge, with 222 companies being added, the weighting could increase over time if the country enacts further reforms. The inclusion will be done in two steps: the first in May 2018 and the second in August of next year.

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“International investors have embraced the positive changes in the accessibility of the China A shares market over the last few years and now all conditions are set for MSCI to proceed with the first step of the inclusion,” Remy Briand, the managing director and chairman of the MSCI Index Policy Committee, said in a statement.

Also Tuesday, MSCI put off decisions on whether to reclassify Argentina as an emerging market and to demote Nigeria to standalone status. It included Saudi Arabia on its watch list for potential classification as an emerging market.

The inclusion of Chinese shares punctuates an extraordinary period during which the country has sought to enter the mainstream of international finance while still maintaining a semblance of control over its markets. Since MSCI first considered adding Chinese shares to its indexes in 2014, the market has experienced an epic boom and bust, a bout of heavy-handed government intervention and -- more encouragingly for foreign investors -- a steady stream of initiatives to connect local exchanges to the outside world.

The MSCI inclusion "will provide a modest boost to sentiment and flows into China," said David Loevinger, a former China specialist at the U.S. Treasury who is now an analyst at fund manager TCW Group Inc. in Los Angeles. "More importantly it strengthens Chinese reformers that want to open China’s markets. The small index weight looks like a compromise between those asset managers that wanted China in and out."

MSCI’s announcement provided a small fillip to the offshore yuan and a bigger boost to U.S.-listed exchange-traded funds, with the Deutsche X-trackers Harvest CSI 300 China A-Shares ETF jumping as much as 3 percent in post-market trading.

MSCI, which has been working directly with China’s securities regulator to resolve hurdles to inclusion since at least 2015, helped bridge the gap between Beijing and reluctant global asset managers with a less ambitious proposal unveiled in March.

To address investor concerns about the number of suspended shares, stocks halted for more than 50 days in the past 12 months weren’t eligible for inclusion. All companies to be added are large-cap shares accessible to foreigners through China’s cross-border exchange links with Hong Kong, including those with dual-listings.

"The next inclusion is probably going to have a larger inclusion factor -- it was 5% of the market cap of those large capitalization stocks -- and potentially, as well, the inclusion of the mid caps," Henry Fernandez, chief executive officer of MSCI, said in a Bloomberg Television interview. "The second category is something that we’re very focused on, we’d like to expand the universe of shares that are available to international investors."

The addition of mid-cap shares would depend on factors included improved accessibility to China’s stock market for overseas investors, the relaxation of daily trading limits, progress on trading suspensions and easing of restrictions on the creation of index-linked investment vehicles, according to MSCI’s roadmap.

International money managers can now buy and sell more than 1,400 domestic Chinese stocks after authorities opened the Shenzhen Connect in December, about six months after last year’s MSCI rejection. The first link with Shanghai started in late 2014.

Inclusion in MSCI indexes will spur about $8 billion to $10 billion more in fund flows to China’s A shares, according to Lucy Qiu, an analyst at UBS Wealth Management’s Chief Investment Office, which oversees strategy for $2.2 trillion in assets.

"Over the long term, assuming further liberalization and regulatory reform of the mainland stock markets, the depth of China’s A-share market could mean China gains substantial weight within those broader indices," said Nick Beecroft, an Asian equity portfolio specialist at T. Rowe Price.

Given their tiny initial weighting, domestic Chinese shares will be dwarfed by the nation’s overseas-traded stocks. The country already has the largest position in the MSCI Emerging Markets Index, thanks to Hong Kong-listed companies like Bank of China Ltd. that joined the gauge years ago. The country’s dominance has only increased recently with the addition of U.S.-traded firms including Alibaba Group Holding Ltd.

In 2017, internationally-listed Chinese stocks have proven a better bet than their local counterparts. The MSCI China Index has advanced 25 percent, trouncing a 1.2 percent gain in the Shanghai Composite Index.

For many investors, China’s local shares represent the future. Not only is the market massive -- the second-biggest worldwide after America’s -- it’s also home to many of the companies most aligned with China’s consumer and service industries, which are seen as key drivers of the $11 trillion economy’s long-term expansion. And while the yuan has been under pressure recently, so-called A shares in Shanghai and Shenzhen give global investors exposure to a currency that’s likely to play a growing role as China expands its economic clout overseas.

"This is the start of a process through which Chinese equities will achieve a prominence in global investors’ portfolios that reflects the size and significance of China’s domestic stock market and its economy," Helen Wong, HSBC’s Chief Executive of Greater China, said in a statement.

Source:
courtesy of BLOOMBERG

by Sam Mamudi and Ben Bartenstein

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