MSCI has announced its decision to include Chinese mainland companies in its broad Emerging Markets Index, after three previous annual reviews that rejected the notion. In May 2018, China A Large Cap shares will be added to the broad benchmark. 

Historically, A shares of mainland China-based companies were only available for purchase by mainland citizens and by certain foreign institutions such as asset managers like OppenheimerFunds.  To paraphrase Neil Armstrong, the MSCI announcement amounts to one small step for A shares with regard to their weighting in the index, but one giant leap in terms of the elevation of China’s status in the global financial markets.

At the beginning, the MSCI Emerging Markets Index will include 222 of the 459 companies in the China A Shares Large Cap Index (including PetroChina, Bank of China, and Air China), and more companies will be added over time.  By August 2018, it is estimated that China A shares representation will increase to their true exposure of approximately 0.74% of the free-float weighted index.  By comparison, Chinese companies that are listed on the Hong Kong exchange, like Tencent, or that trade as American Depositary Receipts on U.S. exchanges, like Alibaba and Baidu, already represent 29% of the MSCI Emerging Markets Index.1

A Long Time Coming for China

China has come a long way since forming its stock exchanges in 1990.  The market capitalization of Chinese equities has grown from nothing in the mid-1990s to USD $6.6 trillion at the end of 2016, surpassing Japan and the UK, and trailing only the U.S. market capitalization of USD $23.8 trillion.1  China is home to many of the world’s most dynamic and innovative companies.  State-owned enterprises now represent less than one-fifth of industrial output, down from nearly 80% in the late 1970s.2

Before the Renaissance period, China represented 30% of the world economy. After World War II and the Cultural Revolution, its economic representation fell to below 5%.2 Since China launched economic reforms in 1978, the country has experienced a staggering transformation.  China is now the world’s second largest economy and the world’s largest contributor to economic activity.  The country is twice as wealthy as it was in 2007 and is successfully transitioning from a manufacturing-based economy to a more consumer-based economy.  In 2016, China surpassed the U.S. to become the world’s largest retail market, with total sales of USD $4.8 trillion, and represents almost half of digital retail sales worldwide. It is estimated that by 2020, some 850 million people, representing roughly 12% of the world’s population and approximately 60% of China’s total population, will be living in China’s urban areas, up from 650 million people in 2010.2

China’s Economic Rise Parallels Korea’s

China’s continued emergence is reminiscent of Korea’s emergence during the past two decades.  Since 1998, when Korea was added to the MSCI Emerging Markets Index, its GDP per capita has more than tripled.2 Additionally, MSCI Korea has doubled the returns of the MSCI All Country World Index (12% vs 6% annualised total returns) since full inclusion in 1998.1  Given tremendous GDP and market growth over the past twenty years, South Korea is consistently in the conversation about it graduating to developed market status. We will be having similar conversations about China in the future.

China remains the most misunderstood economy and financial system in the world.  For all the hand wringing about China’s “overinvestment,” the country’s construction spending is generally in line with that of Korea or Taiwan during their economic booms. We believe fears about China’s debt levels are overstated and misrepresent the financial flexibility the government has at its disposal to respond to potential crises at the local level or within the financial system. 

We prefer to look at the dynamic underlying growth trends taking place within the Chinese economy, and to invest in those companies taking advantage of the seismic shifts occurring in Chinese cities and beyond.  We welcome the China A Share Index’s new status in the MSCI Emerging Markets Index.  To quote Neil Armstrong once again, “Science has not yet mastered prophecy.  We predict too much for the next year and yet far too little for the next 10.”  We believe that investors considering allocations to China over the next decade and beyond are unlikely to be disappointed.

 
  1. a, b, c Source: FactSet, as of 6/22/17. Past performance does not guarantee future results.
  2. a, b, c, d Source: Haver, as of 6/22/17.