China has long been an obsession for intrepid foreign investors. In the modern era, nonetheless, many investors have committed less capital to its markets than their size might otherwise merit, due to restrictions that have only slowly been loosened as the communist country has warmed to capitalism.
But that could be about to change as more global institutional investors pivot towards the celestial kingdom with potentially a $1 trillion-worth of additional portfolio capital seen heading China's way over the next decade.
The trigger? The looming inclusion of 222 China A large-cap shares in the bellwether MSCI Emerging Markets Index, and the additional market liberalisation that could follow.
"We are explicitly seeing demand from the largest institutional investors in the world,” Michael Levin, head of asset management for Asia at Credit Suisse Wealth Management, told AsianInvestor.
"They have limited allocations to China and are being thoughtful about how to increase exposure to corporates in China, including onshore A-shares and bonds, as well as [the] globally listed equities and hard-currency bonds of Chinese companies,” he said.
The A-shares inclusion, scheduled to start taking place this June, will take up just 0.73% of the index. Credit Suisse has estimated that passive equity funds tracking the index would have to invest around $13 billion into A-shares as result.
But industry experts believe this is likely to be just the tip of the iceberg.
Yoon Ng, director at financial data and analytics firm Broadridge Financial Solutions, said: “There's just huge potential for flows into Chinese markets, especially when it becomes a much more open market. Definitely there will be more foreign participation in that marketplace, and we'll likely see a spike in terms of numbers.”
The sheer scale of China has naturally always drawn the attention of investors, she noted, but MSCI incorporating China and increasing the country's weighting within the MSCI EM index are reasons to look at it more closely.
Levin agreed. “When you combine China having the second-largest stock market in the world, healthy growth, index inclusion, and strong market performance," he said, "that creates an urgency for global investors to increase their allocations well in advance of the A-share weighting.”
How much, exactly? “I want to talk about $1 trillion over a 10-year period,” Levin replied. “It makes sense, China provides about one-third of global GDP growth—it’s the largest contributor. Its economy is approximately $12 trillion in size and the market capitalisation of Chinese companies listed globally is already in excess of $10 trillion.”
And, crucially, most global investors are effectively underweight when it comes to their exposure to the world’s second-largest economy.
“If you look at overall positioning in pan-Asian funds or in [emerging market] funds, China’s still underweight, which in our view basically means that there’s still potential that more people will shift into China,” Adrian Zuercher, head of asset allocation for Apac at UBS Wealth Management, told AsianInvestor.
According to Broadridge’s Ng, global investment into China is still a very small part of the total capitalisation of the Chinese market: “Somewhere in the ballpark of less than 5%...is invested by global investors.”
And over last year as a whole that figure even went down, not up; more capital sourced from retail and institutional investors flowed out of Chinese markets in 2017 than flowed in, Broadridge data shows, with equities alone showing a negative net balance of $2.8 billion.
That said, there was a sharp turnaround in the direction of capital late in the year, marking a change in attitudes.
From August-end through December, Chinese equities saw a positive flow of $2.5 billion—the four straight months of net inflows was the longest positive period since the end of 2012, Barbara Ferraresi, global market intelligence product manager at Broadridge, told AsianInvestor.
Credit Suisse’s Levin believes China will increasingly become viewed by investors as a distinct animal, rather than being lumped into emerging market indices.
“Currently, most of the global investors, such as institutions, still do not have a dedicated [China] exposure,” Ng agreed. “There's probably plenty of room to grow.”
She doesn’t expect this to happen right away, due to unfamiliarity with the local markets. “China is really a big and broad market itself and it's not necessarily the most transparent market, so it would take a bit of time for them to build up the dedicated expertise,” Ng said.
“The first step will be getting access via a more regional emerging market exposure, and when they understand the market better I think then they will move on to more of a single market focus,” she added.
Other types of investors have more of a first-mover advantage.
Institutional investors with ties to Chinese corporates have a leg up on their peers, a senior executive at a Hong Kong-based regional insurer, who declined to be named, told AsianInvestor. “We have strong support with our [Chinese ownership group] in respect of investment resources and research capabilities, and we are familiar with China,” he said.
The insurer, which is majority owned by a Chinese conglomerate, is able to take advantage of the conglomerate’s familiarity with different sectors of the market, allowing them to have a heavier exposure to Chinese markets, he said.
“About 40% of our assets under management is invested into Chinese assets, including those securities listed or traded outside of mainland China, such as in Hong Kong and the US markets,” he said.
Levin noted that a particular area of interest for foreign investors today is China’s thriving technology sector, which is seen as having big expansion potential. “Unlike tech companies in US and Europe that have already globalised, China’s technology companies are just beginning to expand geographically,” he said.
China's vast consumer sector is another big draw, given ongoing efforts to reconfigure the Chinese economy more towards consumption as local disposable incomes grow.
“Where there is the ability to tap into the home market, the big domestic consumer market—those would be the areas of key interest for global investors,” Ng said.
There is a push factor also. After decades in which US administrations have tended to talk up the value of the US dollar, President Donald Trump seems happy to discuss a weaker dollar. That potentially increases the appeal of non-US asset classes by giving foreign investors an incentive to diversify away from the world’s largest economy to its next-biggest rival.
The creation of the Stock, Bond and, possibly, ETF Connect channels facilitates such a migration of capital and signals Chinese willingness to relax capital constraints too.
“Over the long term I think there will be a continuation of a reduction in the barriers and quota-specific programmes [that restrict foreign investments into China]," Levin said.
The creation of these investment channels will result in increased exposure in China among institutional investors, the senior executive at the regional insurer agreed, as well as improving corporate governance and transparency among China enterprises.
“That will also help foreign investors to gain confidence to invest in China,” he said.