Capitalising on change in China

Haijing Wang examines the opportunities to be had within China's increasingly open markets

It's been a year since MSCI officially included China A-shares in the MSCI index, and on 28 February 2019, the company announced that it will increase the weight of China A-shares in its indices by increasing the inclusion factor to 20% - up from the initial level of 5%. A-shares are shares in mainland Chinese companies that are traded on the Shanghai and Shenzhen exchanges, denominated in renminbi (RMB).

In December 2018, I wrote an article for The Actuary about how to invest in China; this time, let's discuss why you may want to do so.

Economy size vs asset allocation

China's economy is simply too big to miss out on. However, in the past, it has been heavily under-allocated by global funds. In Figure 1, we can see that it accounts for 15% of world's GDP, but has just 4% of global fund allocations. With MSCI continuing to include China's A-shares in its index, we are expecting correction from global investors. 

Emerging market growth continues to accelerate

The IMF is forecasting that the growth rate of emerging countries will rise slightly during the next few years (Figure 2), with China at the vanguard of this expansion. While the growth of the country's economy might be slower in this period than it has been in the recent past, its quality will improve as its technology sector develops - and its growth rate is still well above that of developed countries.

Attractive valuation of China's stock market

Equity is one of the most important asset classes to get exposure to China's growth. China's A-shares are considered to be cheap compared to other equity markets. As shown in Figure 3, the price-to-earnings (P/E) ratio of China's equity market is only 13.7x, which is lower than the US market's 22x and the Japanese market's 16.4x. If we look at China's equity price time series (Figure 4), it shows that A-shares' P/E ratio is now at its lowest point of the past two decades.

Looking at overseas funding preferences and asset allocation styles, taking the top 100 stocks of the Mainland China-Hong Kong Stock Connect and Qualified Foreign Institutional Investors' (QFII) fund positions as samples (Figures 5-8), we can conclude that foreign funding has a preference for:

• Medium and large cap stocks with a market capitalisation of $1.5bn-$7.5bn or more
• Value stocks with a P/E ratio below 40x.

In terms of industry, the Mainland China-Hong Kong Stock Connect and the QFII funding prefer the consumer sector (food and beverage, pharmaceuticals and biotechnology, household appliances). In the finance sector (banks, non-banking financial institutions), the QFII funding's allocation to banking sector is higher, while in non-banking institutions it is lower, compared to Mainland China-Hong Kong Stock Connect. The QFII has a higher proportion of undervalued positions, with P/E below 10x due to this higher allocation to the banking sector.

The market is sizeable enough for foreign investors. Since 2007, the ratio of Sino-US market capitalisation remains at a level of 20% (Figure 9). The turnover ratios of CSI 300 and S&P 500 are both improving and comparable (Figure 10).

Sino-US interest spread continues to converge

Fixed income is another important asset class for investors. Taking China and US 10-year government bonds as an example, the historical spread level is 100bp; the current spread level is 85bp. China's GDP growth rate has dropped from 8% to 6.5% and the Chinese government has now shifted focus to the quality of GDP, rather than its growth rate. Major investment banks in China have reacted positively to this shift. We see more space for the long-term growth rate to fall, making the government bonds attractive in the long run. 

With the gradual increase in the openness of the Chinese bond market, especially once government bonds are included in the global key bond index, the Chinese bond market will further enhance its position in the global bond market.

Diversification

The diversification effect on equity is also a consideration. Looking at the historical figures, the correlation between US equity and China equity is 16%. Compare this to the 80% correlation between US and UK equity. Investment in China's equity gives foreign investors better diversification.

In summary, China's economy is sizeable and growing, and more and more institutions are turning their gaze towards its growing capital market. Further opening up and reformation in China will make this capital market increasingly transparent and accessible for global investors 

In a press release discussing the increasing weight of China A-shares in the MSCI index, Remy Briand - MSCI managing director and chairman of its Index Policy Committee - says: "Stock Connect has proven to be a robust channel to access A-shares. The successful implementation of the initial 5% inclusion of China A-shares has been a positive experience for international institutional investors and has fostered their appetite to increase further their exposure to the mainland China equity market."

In a press release discussing the increasing weight of China A-shares in the MSCI index, Remy Briand - MSCI managing director and chairman of its Index Policy Committee - says: "Stock Connect has proven to be a robust channel to access A-shares. The successful implementation of the initial 5% inclusion of China A-shares has been a positive experience for international institutional investors and has fostered their appetite to increase further their exposure to the mainland China equity market."