China A-Shares Emerging or Developed

Emerging or Developed? One China, Two Narratives


Assuming all goes according to plan, on June 1, 2018, MSCI will begin including China A-shares in several of its indexes. The decision, first announced nearly a year ago after a series of delays, represents another milestone in China’s increasing recognition on the global stage. But MSCI’s decision—opting to include only a small percentage of the A-shares in its index weighting—reflects the confusing situation encountered when trying to classify China as emerging or developed.

Developed economy, emerging market

In the past decade, China’s economy has grown to be the largest in the world, while its stock market (counting both mainland and offshore listings) has become the second largest. Despite this growth, the country is still classified as “emerging” by the major index providers. To many investors this seems quizzical, but it primarily reflects a difference in nomenclature. While many would contend that China’s economy as a whole is close to becoming developed, the index providers are classifying China’s equity markets as emerging, due to some characteristics that are counter to what’s considered a well-functioning equity market in the developed world.

The difference between these two definitions underlies MSCI’s reluctance to include China A-shares in its index at their full market-cap weight, since many of the market practices on the mainland are far from what are required under MSCI’s criteria to be considered a developed market (and, arguably, don’t even yet fully meet the standard to be considered an emerging market).

The table below lays out the rough criteria MSCI applies when considering how to classify a country (other index providers have similar, but not identical, conditions):

China A-Shares

Source: MSCI

Going through these criteria illustrates the problem with classifying China’s mainland securities as developed, emerging, or frontier. The first criterion (economic development) measures the average citizen’s income level, and China is quite close to meeting the World Bank’s definition of high income. As stated, this criteria supports MSCI’s current classification of China as emerging. Note that this is the closest equivalent to what’s commonly meant when investors say China is practically a developed economy—it’s become a relatively rich country in the global context.

The second criterion (size and liquidity) argues for China to be considered a developed market, since the mainland exchanges have dozens of large, liquid stocks that meet the market-cap and float requirements. The third criterion (market accessibility), however, is the most qualitative, addressing what it means for a market to have developed-like structures and practices. It’s also where the qualifications of the A-share markets look least robust.

How accessible are China A-shares?

While mainland shares on the Shanghai and Shenzhen exchanges are available to investors through the nation’s Stock Connect programs, these suffer from daily quotas and, as the chart below shows, offer access to only a limited portion of the A-share universe.

China A-Shares

Source: Shanghai Stock Exchange, Shenzhen Stock Exchange, Standard & Poor’s

Similarly, it’s hard to claim that the ease of capital inflows and outflows are anywhere near developed, and given the capital controls maintained by the central government, A-shares seem not to meet the criteria to be emerging. Finally, given the well-documented ability of companies to halt trading at their own discretion (which was particularly impactful during the summer of 2015, when  50% of the companies chose to do so, or more recently, when insurer HNA declared months-long trading halts for many of its listed subsidiaries), it’s hard to maintain that that the efficiency of the operational framework is “good and tested,” let alone merits the “very high” ranking needed to classify the market as developed.

All of this speaks to the historically unique problem MSCI (and global investors) find themselves grappling with—China is a nation that’s on the brink of being economically developed but still retains market practices more commonly associated with a frontier-market country. This conundrum has led to MSCI’s delay in its initial inclusion of A-shares, and even now MSCI is choosing to include only a small fraction of their representative weight while it encourages Chinese authorities to make needed market reforms.

The bottom line

China’s mainland markets still demonstrate some remarkably investor-unfriendly characteristics that belie the country’s advanced stage of economic development. While MSCI’s initial allocation of approximately 75 basis points to China A-shares seems appropriate, this allocation is predicted to grow to a 15–20% index weight. Accordingly, investors would be well served to make sure they agree with MSCI’s assessment of market accessibility—or, if not, to move to a benchmark that either excludes A-shares or allocates them in a way that better reflects investors’ A-share concerns.

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Tim Atwill

Tim Atwill, PhD, CFA, Head of Investment Strategy (emeritus)

Tim led the Investment Strategy Team at Parametric, which is responsible for all aspects of Parametric’s investment strategies, until his retirement in 2019. He also held investment responsibilities for Parametric’s Emerging Markets and International Equity strategies as well as shared responsibility for the firm’s Commodities Strategy.

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