Accessing the Chinese domestic growth story
by William Baunton
Mon 10 Nov 2014
What the chart shows: The chart outlines the performance of the three largest constituents of the Chinese A-share market, Ping An Insurance, China Merchants Bank and China Minsheng Bank, worth a collective $67.5bn, from 1 March 2007 to 4 November of this year. After exceptional growth towards the end of 2007, when two of the companies tripled in market value, the stock prices retreated and have changed little over the last seven years.
Why it is important: The barriers to investing in Chinese companies are coming down. Until recently, foreign investors were effectively blocked from investing in China by tight capital flows and a ban on buying the most sought after shares in companies. A-shares, the renminbi-denominated stocks of companies incorporated in China, are the largest share class listed on the Shanghai and Shenzhen exchanges, and are available only to domestic Chinese investors at present. Foreign investors have been able to purchase B-shares, denominated in foreign currencies and with inferior voting rights.
A-shares, crucial for accessing and capturing growth in China, are one of the largest, most liquid equity markets in the world. China contributes 12% of the world’s GDP, but only accounts for a small proportion of world equity (2% of Morgan Stanley Capital International’s (MSCI) world equity index), suggesting great untapped potential. A-shares make up roughly 34% of the total assets available for investment in China, which are missing from a typical foreign investor’s portfolio.
Access to the $4.2tn A-share market has potentially large diversification benefits to global investors. The Chinese market historically has very low correlation with world markets: 0.39 with developed markets and 0.49 with emerging markets (MSCI indexes). It moved in the opposite direction to the MSCI World Index 35% of the time in the last nine-and-a-half years. This low correlation is linked to trading restrictions, low foreign participation and asymmetric information available to the market, down to heavy intervention by the government and state-owned enterprises.
In 2002 a small step towards opening China’s market to foreign investors was taken with the introduction of the Qualified Foreign Institutional Investor (QFII) licence. This allowed holders to buy and sell A-shares under a collection of restrictions and limitations, which were gradually relaxed over the years, along with the introduction offshore RMB clearing centres. A larger step was supposed to be taken last month with the launch of the Shanghai-Hong Kong Stock Connect, which would have allowed easier access to mainland shares and removed the need for a licence. But the scheme was delayed at the 11th hour. Little detail was given on why regulatory approval was not granted, and speculation has grown that the delay was a reaction to the Hong Kong pro-democracy protests. Today it was announced that the scheme has finally been approved by all regulators and stock exchanges, as expected with Beijing’s view that markets need to be opened up; it commences on 17 November. Stocks both in Shanghai and Hong Kong jumped in response to the news today, with gains of around 5% in morning trading in Hong Kong.
There are many questions surrounding the scheme and whether foreigners will be enticed to invest straight away. Restrictions involved, aside from the $3.8bn daily cross-border purchases limit, and the tax treatment, have also not been completely clarified. Low reporting standards and shady corporate governance in mainland China are further worries, adding risks associated with asymmetric information. There remain difficulties surrounding initial public offerings, as demonstrated by Alibaba listing on the NYSE after failing to come to an agreement in Hong Kong. Another fear is that the Chinese economy will experience a ‘hard landing’, with growth slowing and speculation of the credit bubble popping.
Beijing’s goal is to move towards greater openness generally, and to allow retail investors, such as pension funds, to become active in the market to reduce China’s dependence on exports and infrastructure spending. Foreign investors appear eager, but time will tell how much they will hold of these Chinese stocks in their global portfolios.