Managing the Transition with FTSE Global China A Inclusion Indexes
On May 26, 2015, FTSE Russell introduced the FTSE Global China A Inclusion Indexes as a transitional tool in preparation for the potential inclusion of China A-shares in its widely followed global benchmarks. These indexes were designed in response to the gradual liberalization of the Chinese capital markets, as evidenced by the growth of the QFII and RQFII schemes and the introduction of the Shanghai-Hong Kong Stock Connect program.
Recent volatility in China’s stock markets seems unlikely to derail the Chinese government’s long term agenda of market liberalization. The liberalization of the country’s capital markets is but one of the components of the financial reform agenda introduced by the government. Other fundamental elements of this program include adjustments to interest rate policy, the reform of the country’s banking system, and the internationalization of the renminbi (RMB).
Despite this progress, the China A-shares will remain, for the time being, on the Watch List for prospective inclusion in FTSE’s standard Global Equity Index Series (FTSE GEIS), as per FTSE’s Annual Country Classification announcement of September 2015. Changes relating to market accessibility, capital repatriation and clearing and settlement remain unresolved. FTSE Russell will continue to coordinate with market participants and the Chinese authorities toward a satisfactory resolution of these technical obstacles.
In the meantime, FTSE Russell offers market participants the FTSE Global China A Inclusion Indexes, a series of global indexes that add China A-Shares to FTSE GEIS. The inclusion indexes seek to reflect both the actual composition and the changing dynamics of China’s A-Share market while providing a set of flexible options to international investors facing different access constraints.
FTSE Russell is a leading global benchmark provider with more than 14 years of experience in China indexes, and considers the FTSE Global China A Inclusion Indexes to be the next logical step in FTSE Russell’s global benchmarks development.
Figure 1 below illustrates the magnitude of the difference in weighting under various pro forma scenarios.
Source: FTSE Russell, data as at 31 December 2015
China A-Shares: World’s Second Largest Equity Market
China’s explosive economic development has been accompanied by a similar expansion of its equity markets. Beginning with a mere eight listings on the Shanghai Stock Exchange (SSE) in 1990, there are now more than 2600 companies listed on the SSE and Shenzhen Stock Exchanges (SZSE). Their combined market capitalization reached US$ 10 trillion in June[i] before dropping by US$3.2 trillion, or twice the size of India’s market, within a few weeks.[ii] Despite these huge swings China consistently ranks as the world’s second largest equity market in term of market value after the USA.[iii]
Incorporating A Shares: Broader Representation of the Chinese Economy
Accessing the A-shares market is increasingly viewed by international investors as necessary for gaining a more accurate representation of the underlying Chinese economy.
There are more than 650 China A-shares constituents in the FTSE China A Index, compared with 232 B-share, H-share, Red Chip, and P Chip constituents in the existing FTSE Emerging Index. As shown in Figure 1, the free float adjusted market cap of A-shares is almost twice as large as B, H-shares, Red and P Chips combined. Ignoring A-shares would mean ignoring a large part of the Chinese equity market.
Companies listed on the domestic exchanges in China can differ substantially in profile from those listed outside of mainland China. The Shanghai Stock Exchange is the preferred exchange by industrials and services sector companies. The Shenzhen Stock Exchange has emerged as the preferred market for Chinese tech upstarts often unknown outside of China. Listings outside of China have, for historical reasons, seen a concentration of companies linked to state-owned enterprises as well as large financial institutions.
The exclusion of A-shares from global indexes limits diversification and restricts market participants from assessing certain growth sectors not necessarily captured by overseas China indexes. As China continues to develop, the relative importance of the A-shares market will continue to grow. With over 600 companies seeking regulatory approval from the Chinese regulator, the Shanghai and Shenzhen stock exchanges will better reflect the shifting dynamics of the Chinese economy as it transitions from an export orientated economy to one that is a consumer led.
Potential Diversification Benefits of Including A-Shares
From a global investor’s perspective the inclusion of A-shares in a global portfolio could potentially bring diversification benefits. Figure 2 indicates that the correlation between the FTSE China A All Cap and the FTSE Global All Cap Index is less than 40% over the last eight years.
Figure 2. Correlation Between FTSE China A All Cap and FTSE Global All Cap Indexes (2005 to 2015)
Source: FTSE Russell, data as at 31 December 2015. Returns shown may reflect hypothetical historical performance. Past performance is no guarantee of future results.
Routes for Accessing A-Shares Market
The gradual liberalization of the Chinese stock market has led to a number of policy changes over the years, which has resulted in a variety of routes for international investors to access the A-share market, but subject to conditions sometimes onerous to investors.
QFII/RQFII: Only Qualified Investors Need Apply
Approved international investors may trade A-shares through two schemes, namely the Qualified Foreign Institutional Investor (QFII, launched in 2002) and the Renminbi Qualified Foreign Institutional Investor schemes (RQFII, launched in 2011). These schemes are reserved to investors approved by the China Securities Regulatory Committee (CSRC), while the investment quotas apportioned are granted by the State Administration of Foreign Exchange (SAFE). The quotas granted under these schemes have increased substantially in the last three years to reach USD81 billion for the QFII and Rmb 444 billion (USD68 billion) for the RQFII schemes at the end of 2015.
The QFII regime allows registered foreign institutional investors with investments denominated in a foreign currency to invest directly in A-shares but under strict quota allocation and trading procedures. There are over 200 licensees under this scheme.
The RQFII program is a variation of the QFII that facilitates foreign investment in the mainland via offshore renminbi accounts. Investors’ qualification criteria, quota approval and trading and settlement processes are significantly more flexible under the RFQII scheme as compared with the QFII scheme. There are over 170 licenses under the RQFII scheme.
The criteria used for status approval have been progressively relaxed for both schemes, while 14 jurisdictions including the UK, Singapore, France, Germany, South Korea, Australia and recently Malaysia joined Hong Kong as offshore centers allowed to use RMB to invest in Chinese A-shares under the RQFII program. Tradeable products have also expanded to include fixed income and index futures.
While these investment schemes allow foreign investors to trade A-shares, investors are still subject to a strict quota system.
The Connect Program: Open To All
Launched in November 2014, the Shanghai-Hong Kong Stock Connect program allows Hong Kong and international investors to trade China A-shares and mainland investors to trade Hong Kong stocks within a certain daily quota limit. It is expected that authorities in China and Hong Kong will launch a similar program for shares traded on the Shenzhen Stock Exchange in 2016.
Unlike the QFII and RQFII schemes, the Connect program is open to all investors, institutional and retail alike. In addition, investors are not required to receive any quota approval from the regulatory authorities in order to trade, and are not impaired by currency controls and reporting requirements. The introduction of additional connect programs would be a further indication that the Chinese government remains committed to capital markets liberalization.
Mutual Recognition Scheme: Funds For All
Launched on July 1, 2015, the Mutual Recognition of Funds (MRF) scheme allows for the first time registered asset managers operating in Hong Kong and mainland China to sell their funds within their respective jurisdictions. An initial quota of Rmb 300 billion (USD48 billion) has been set aside for each direction of the MRF scheme.
The MRF scheme allows equity, fixed income, mixed and index funds to be eligible for cross-border selling, where asset managers need to appoint a local agent to market and distribute their funds.
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