Preparing for China’s inclusion in global benchmarks - A flexible approach to managing the transition
- Following further increases in R/QFII allocations and improvements in the R/QFII application process, on May 26, 2015 FTSE Russell announced the start of its transition to include China A-shares in its widely followed global benchmarks, with the launch of FTSE Global China A Inclusion Indexes.
- Over the years, China continues to open its market to foreign investors at a significant pace. It is increasingly likely that within two to three years China A-shares will become eligible for inclusion in FTSE's global indexes. To facilitate this growth in access, the FTSE Global China A Inclusion Indexes were launched to give market participants a range of index choices to help them prepare for the inclusion of China A-shares in global benchmarks.
- At the time of the launch, there was no change to the standard FTSE Global Equity Index Series. Based on FTSE's Annual Country Classification announcement, dated September 2017, China A-shares are not yet eligible for FTSE Russell's standard global benchmarks. For inclusion further progress is required as part of FTSE's country classification process in two criteria: capital mobility and settlement and clearing.
- FTSE Russell will continue to consult and engage with market participants and the Chinese authorities to monitor developments and gauge progress in these key areas. A formal review of the status and eligibility of A-shares will be held every September. The next review is due in September 2018.
- The FTSE Global China A Inclusion Indexes were created to prepare market participants for the inclusion of China A-shares in FTSE Russell's standard indexes. Accordingly, market participants have the following benchmark options:
- Global benchmarks with China A-shares included and weighted by the aggregate approved quota (including QFII/RQFII)
- Global benchmarks with China A-shares included and weighted by free float and foreign ownership- adjusted market value as if there were no quota restriction
- Customized indexes based on an investor's own QFII/RQFII allocation
- Market participants who do not wish to have China A-shares in their global benchmarks can continue to use the FTSE Global Equity Index Series.
- The index series provides a range of benchmark choices reflecting alternative ways for market participants to access the mainland China market. It has been created for clients:
- Who would prefer to increase their China exposure over a period of time;
- Who have no quota constraint and would prefer a higher allocation to China A-shares;
- Who prefer having an allocation to China A-shares based on their own quota size.
- With over 16 years of experience developing China market indexes, FTSE Russell's China benchmarks have become widely recognized by investors and ETF issuers globally as the leading measure of the China equity market and the natural choice for creating China-themed investment products.
China has shown strong indications that it is willing to open its market to international investors. The approval process of QFII/RQFII licenses has been further simplified and the criteria for determining quota size are more transparent. The launch of the Shenzhen-Hong Kong Stock Connect programme on December 5, 2016, following the success of the Shanghai-Hong Kong Stock Connect programme, has shown clear evidence that the Chinese regulators and stock exchanges are making significant efforts to improve the regulatory environment and trading mechanisms.
An increasing number of investors are asking questions such as: When will China be included in global benchmarks? What can investors do to prepare for a possible inclusion? This paper aims to answer these questions and is intended for market participants as they prepare for China’s inclusion in FTSE Russell’s global benchmarks.
Sections 1 and 2 describe the development of the China A-shares market and the milestones towards its globalization. The FTSE country classification system and the assessment results on China are discussed in Section 3. Section 4 outlines FTSE Russell’s solution to the China A-shares market changes. Conclusions can be found in Section 5.
1. China’s development and its importance to global investors
Following the implementation of market reforms in late 1970s, China has become one of the world’s fastest-growing economies. Over the past few decades, it has evolved to become the largest manufacturer and the second-largest economy by GDP.
Since the establishment of the Shanghai and Shenzhen Stock Exchange in the early 1990s, the Chinese equity market has been developing at a significant pace. The first public trading commenced on December 19, 1990, with eight companies listing on the Shanghai Stock Exchange. Shortly afterwards, the Shenzhen Stock Exchange opened. There are now over 3000 companies listed on the two exchanges with a combined market capitalization that exceeds USD 7 trillion[i]. This makes China the second largest equity market by market value. China’s role in the global equity market has become increasingly important and attracted significant investor attention.
Although the Chinese equity market represents a significant portion of the global equity investment landscape, there are still some restrictions in market accessibility for the China A-shares market. As the China A-shares market gradually opens, it is important for investors to understand the potential impact that an easing of such restrictions would have on their global benchmarks.
FTSE Russell, as the leading international index provider of Chinese indexes, has been a part of this remarkable evolution since the beginning of this century. Since then it has provided Chinese domestic and international indexes to global and domestic investors. Its two flagship China indexes – the FTSE China 50 Index and FTSE China A50 Index, were designed to provide tools to investors with and without access to the domestic Chinese market. As of June 30, 2017, ETFs and funds tracking the FTSE China A50 Index and FTSE China 50 Index had assets under management of USD 7.1 billion and USD 4.2 billion, respectively.
2. Milestones towards globalization
The size of the China A-shares market is significant. However, it is only relatively recently that the idea of the possible inclusion of China A-shares into global benchmarks has started to emerge. This emergence can be attributed to three major developments in China; the expansion of the stock market, regulatory improvements and easier market accessibility for international investors. These three developments have led FTSE Russell to consider the inclusion of China A-shares into its global benchmarks.
2.1 Chinese regulatory reform
The China Securities Regulatory Commission (CSRC), established in 1992, is responsible for performing centralized supervision and regulation of the securities and futures markets on the Chinese mainland. Under the guidance of the CSRC, self-regulated organizations including the Shanghai and Shenzhen Stock Exchanges are responsible for the direct supervision over securities of listed companies trading on the exchanges’ platforms.
There have been a number of regulatory reforms which are widely considered as positive steps towards opening the China A-shares market. In 2005, the CSRC proposed the elimination of non-tradable shares held by government and quasi- government authorities, which resulted in improvements in liquidity and the overall pricing mechanism of the stock market.
In the same year the CSRC tackled the issues of misappropriation of funds held on behalf of clients in securities firms and fund management companies. Completed in 2008, it introduced a requirement to use third party custodians for handling client property, and prohibited securities/fund management firms from dealing directly with client funds.
The Code of Corporate Governance for Listed Companies in China was issued by the CSRC in 2001, stating the basic principles for corporate governance of listed companies, and the protection of investors’ interests and rights. In December 2013, the State Council of the People’s Republic of China issued nine new suggestions to further improve the equity market and protect the legal rights of minority shareholders. The proposed enhancements include improving information disclosure, the compensation system and strengthening investor education.
In November 2013, the CSRC also provided additional guidance on the regulatory requirements of new listings. The reform aims to increase the protection, rights and interests of investors. Specifically, it urges issuers to use plain language to provide accurate and complete company information, enabling investors to make informed investment decisions. Other areas of attention include promoting fair and reasonable pricing, restricting high pricing by issuers and curbing speculation in new listings. The CSRC has also enhanced the regulation by applying it to non-listed companies that gain access to market funding through the purchase of a listed firm. The so called “backdoor listing” reform stipulates that non-listed companies will need to meet equivalent standards to those of an IPO approval.
All these reforms and regulatory changes represent positive steps towards the opening of the China A-shares market and are considered significant developments by international market participants interested in investing in the local market.
2.2 Accessibility of the China A-shares market
(i) QFII/RQFII schemes
Under the current regulations in the People’s Republic of China (PRC), international investors and managers from certain jurisdictions are allowed to use the mainland China A-shares market via the Qualified Foreign Institutional Investor (QFII) or the Renminbi Qualified Foreign Institutional Investor (RQFII) schemes. Approval of status is required from the CSRC while investment quotas (if exceeding the basic quota) are granted by the State Administration of Foreign Exchange (SAFE). The QFII and RQFII schemes were launched in 2002 and 2011 respectively.
Both schemes have gone through a series of changes since their launch and the changes in the past five years were significant. From the end of December 2011 to the end of June 2017, the QFII and RQFII quota available to foreign investors increased from USD 30 billion to USD 150 billion and from RMB 20 billion (USD 3.2bn) to RMB 1740 billion (USD 256.6bn), respectively.
In the past 5 years, seventeen countries including UK, Singapore, France, Germany and South Korea joined Hong Kong as offshore centres and are allowed to use Renminbi to invest in Chinese securities under the RQFII scheme. In addition to increasing quotas, the CSRC has relaxed the eligibility requirements criteria for the QFII and RQFII schemes. Last year, the People’s Bank of China (PBoC) and the SAFE further loosened the quota control for both the QFII and RQFII schemes. In the past 3 years, the total number of licensed QFIIs and RQFIIs increased by 52 per cent to 533 licenses and the total quota approved increased by 78 per cent to USD 172.9 billion (QFII: USD 92.8bn and RQFII: USD 80.1bn).
One might expect the relaxation of eligibility requirements for the QFII and RQFII schemes would mean more investor groups becoming eligible. Interestingly, the QFII and RQFII quota has been issued mainly to asset managers, followed by securities companies, sovereign wealth funds and commercial banks as shown in Figures 2 and 3. We expect this pattern to change as more pension funds seek to diversify their equity exposure as the Chinese market becomes more accessible to international investors.
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