This article was written by Minny Siu, Richard Mazzochi, David Mu, Jessie Ng and Marina Lauer.
Tomorrow, MSCI Inc. ("MSCI") will release the results of its 2017 Annual Market Classification Review. There has been intense market focus on whether China A-shares will be, after the previous 3 attempts, included in the MSCI Emerging Markets Index.
MSCI's decision will ultimately be based on its Global Investable Markets Indexes Methodology, which includes 18 measures across its market accessibility criteria. If tomorrow's review supports the inclusion of China A-shares, this would be another significant breakthrough for China's equity market and attract new mandates from investment funds and financial products rebalancing their asset allocation to include China A-shares.
We will publish a series of articles relating to the legal issues concerning the China A-shares market and the existing investment channels to access this market. In this first alert of our series of publications relating to China A-shares and related developments, we recap the background to MSCI's decision, MSCI's revised proposal for inclusion and the remaining critical accessibility issues, as well as the key potential issues for global investors considering investment in China A-shares through the various access channels.
MSCI's proposed A-shares inclusion: the history
China A-shares refer to RMB-denominated shares listed on the Shanghai and Shenzhen stock exchanges. MSCI first proposed reviewing A-shares for inclusion in June 2013 and has conducted consultations as part of its broader MSCI Market Classification Review on an annual basis since 2014. While MSCI has a number of indexes containing A-shares, MSCI's existing China Index and global composite indexes such as the MSCI Emerging Markets Index and the MSCI All Countries World Index have not yet included China A-shares in their constituent baskets.
While MSCI has acknowledged that China A-shares represent significant opportunities for growth and diversification, it cited the following three main unresolved issues as the basis for declining to include A-shares in its major indexes in its 2016 Annual Market Classification Review:
- effective implementation of the QFII policy changes and removal of the 20% monthly repatriation limit;
- effective implementation of new trading suspension treatment; and
- removal of financial product pre-approval requirements by the local exchanges.
Details of these three unresolved issues are set out below.
At the time of its initial consultation paper in March 2014, MSCI cited a "rapidly growing international investor base in the China A-share market" and positive market opening measures including "the expansion of the RQFII program to London and Singapore, the doubling of the size of the aggregate quota ceiling (RQFII and QFII ), the shortening of the repatriation restriction from monthly to weekly for QFII open-ended funds, and the acceleration of investment license requests and quota approvals" as reasons to consider inclusion.
Since that initial consultation, there have been significant developments in the accessibility of the China A-shares market, culminating in MSCI's latest consultation paper which identified only three remaining critical accessibility issues, discussed below.
What is MSCI's latest proposal for its 2017 Review?
In this section, we outline the current proposal, certain elements of which MSCI significantly revised earlier this year.
Aspects of the proposal which remain the same
MSCI retains its proposal for a 5% partial inclusion of China A-shares in the MSCI China Index, to be simultaneously reflected in corresponding composite indexes including the MSCI Emerging Markets Index, MSCI All Country Asia ex Japan Index and MSCI All Countries World Index. This has not changed from previous proposals.
This progressive partial inclusion aims to balance the full range of investable opportunities and the developing liberalisation of the China A-shares market against the remaining concerns of global investors. The 5% inclusion factor is applied to address the remaining non-critical accessibility issues, including taking into account a 30% foreign ownership limit. The inclusion factor will be increased in line with developments in accessibility of the market, with the eventual aim of full inclusion.
What are new features of the proposal in the current review?
This year, there are new aspects to the proposal which are designed to overcome remaining critical accessibility issues — accessibility issues for global investors which would otherwise have prevented MSCI from including A-shares.
These new aspects include the introduction of further limits on the proposed eligible equity universe, such as reducing it to Large Cap stocks available via the Stock Connect Schemes which have not been suspended for more than 50 days in the past 12 months.
These and other additional limits drastically shrink the proposed eligible stocks from 448 to 169 securities. The overall weighting of China A-shares would be approximately 1.7% in the MSCI China Index, 0.5% in the MSCI Emerging Markets Index and 0.1% in the MSCI All Countries World Index — around half that of the previous proposal.
More specifically, MSCI's revised proposal now excludes from the eligible equity universe:
- 178 Mid Cap securities;
- 61 A-shares in companies which already have H-share constituents included in the MSCI China Index (this is to reduce overlap exposures with marginal weight);
- 32 securities suspended for more than 50 days in the past 12 months; and
- 8 securities not eligible for trading via the Stock Connect Schemes.
This is believed to increase the probability of a positive decision on A-shares inclusion.
3 critical accessibility issues remained after MSCI's 2016 Review
1. Capital mobility restrictions, especially the QFII monthly repatriation limit
According to MSCI's latest consultation paper, the QFII monthly repatriation limit, which limits a QFII's monthly repatriation to 20% of its previous year's net asset value, was a critical accessibility concern for investors, preventing inclusion last year.
However, in MSCI's latest proposal, the selected A-shares have been narrowed down to those with enhanced accessibility (for example, those A-Shares that can be traded by foreign investors through Stock Connect Schemes in addition to (R)QFII channels).
2. Trading suspensions
Last year, investors were waiting to observe the implementation of clarifications on trading suspension policies, which require companies to submit reasons and documentation in order to apply for suspension, given by the Shanghai and Shenzhen stock exchanges. In its latest consultation, MSCI recognised that despite the fact that the frequency and extent of voluntary suspensions continues to exceed those of other parts of the world, suspensions have returned to pre-crisis levels.
The revised proposal is also intended to significantly reduce the number of trading suspensions. In particular, while MSCI had already proposed to exclude China A-shares suspended for more than 50 days, MSCI has now additionally proposed to exclude any securities which have been suspended for more than 50 days in the past 12 months.
3. Pre-approval requirements for financial products linked to A-share indexes
MSCI has been in discussions with the Shanghai and Shenzhen stock exchanges regarding their pre-approval requirements for structured products issued in China or overseas which rely on indexes that include A-shares. These pre-approvals apply to financial institutions offering both new or existing financial products on any stock exchange internationally, where those financial products are linked to an index that includes China A-shares.
In its press release following the 2016 Market Classification Review, MSCI commented:
The breadth of the restrictions is unique in Emerging Markets, as is the possibility that existing financial products based on the MSCI Emerging Markets Index would be in danger of having their trading disrupted if China A shares were included in Emerging Markets and a Chinese exchange withheld its approval of MSCI's licensing of the MSCI Emerging Markets Index as the basis of that product.
In summary, the 3 critical accessibility issues remaining were:
Amongst the 3 identified critical outstanding issues, the key hurdle relates to the pre-approval requirements on the creation of China A-share related products from the China side. It is yet to be seen if any breakthrough discussion will be announced soon to address this concern.
… but the Stock Connect Schemes are now the focus for inclusion
The Shanghai-Hong Kong Stock Connect and Shenzhen-Hong Kong Stock Connect ("Stock Connect Schemes") were launched at the end of 2014 and 2016 respectively (see our KWM Connect on Stock Connect). MSCI has been seeking global institutional investors' feedback on critical issues regarding the accessibility of China A-shares through the Stock Connect Schemes under its new proposal. Investors may raise some of the key issues in trading through the Stock Connect Schemes, such as:
- Daily quotas. For each Stock Connect, a daily quota limits the maximum net buy value of all northbound buy trades that can be executed by Stock Connect exchange participants on any trading day. The daily quota is currently RMB 13 billion for both Stock Connect Schemes, but can change from time to time without prior notice. If the quota is reached, buy orders cannot be completed, although investors may continue to sell securities and may also cancel their buy orders. If A-shares are included in the MSCI China Index, northbound investment and the risk of daily quotas being hit may increase significantly.
- Differences in trading days. There is a difference in trading days between the Shanghai and Shenzhen Stock Exchanges and Hong Kong Stock Exchange, which may be a cause for concern for investors, particularly as the Stock Connect Schemes are closed for northbound trading when there is a public holiday in either Hong Kong or the Mainland, as well as where there will be a public holiday on a payment settlement day.
- CNH liquidity. Currently, trading and settlement via the Stock Connect Schemes occur in RMB only. In the case of northbound trading, increased trading would put pressure on CNH as investors and brokers must purchase CNH in Hong Kong. While MSCI's revised proposal is to use the offshore exchange rate for index calculation to minimise currency drag or any tracking error due to CNY/CNH divergence, this will not address any investor concerns about liquidity.
To address tracking error or replication risks arising from investors accessing China A-shares only via the Stock Connect Schemes, MSCI has pre-emptively proposed to:
- ensure index changes linked to corporate events and the MSCI quarterly index review will be postponed to the next day if such adjustment event falls on a day on which the Stock Connect Schemes are not open or are closed due to reaching a daily limit; and
- exclude IPO stocks from its eligible China A-shares list, as investors investing through Stock Connect Schemes cannot participate in initial offerings.
The Stock Exchange of Hong Kong has indicated that it will request removal of the daily quota limit or an increase in the daily quota for northbound trading, and consider acceptance of HKD or USD on T+0 to ease potential investors' concerns regarding CNH liquidity, to support MSCI's decision to include China A-shares.
Operationally, investors may still face a range of trading risks by investing through the Stock Connect Schemes, including liquidity risk, price fluctuation risk, execution risks and, in the case of funds, unit creation and redemption risks, but these risks could now be categorised as "manageable" rather than "critical", especially given the smaller proposed equity universe and progressive partial inclusion.
In summary, whilst the revised proposal will not eliminate entirely the potential risks arising from investments in China A-shares, it seeks to manage replication risks for those investing through the Stock Connect Schemes, and to mitigate most of the critical accessibility issues investors have identified in past consultations.
On 24 May 2017, MSCI Chairman and CEO Henry Fernandez said there were still "a lot of issues to resolve in a short period of time". In particular, the pre-approval requirements for listed products linked to China A-shares is still a significant issue that remains to be addressed and resolved.
We very much look forward to seeing whether, after four consecutive years of consultation, MSCI will give its stamp of approval in its announcement tomorrow.
 RQFII refers to Renminbi Qualified Foreign Institutional Investors.
 QFII refers to Qualified Foreign Institutional Investors.
 The 2017 MSCI Market Classification Review Announcement will be released on Tuesday, 20 June 2017 at 10.30pm Central European Summer Time.