Executive Summary
- On June 9th, MSCI stated that onshore Chinese equities will be added to their broad-based international indices.
- We believe investors should consider taking a position in the onshore markets today as international investment increases and China implements policies to sustain the onshore market rally.
- Three issues need to be resolved before immediate inclusion can take place.
MSCI, a leading provider of index solutions globally, announced on Tuesday, June 9th that onshore Chinese equities will be added to their broad-based international indices upon the resolution of three outstanding issues. We previously wrote about the potential impact of this inclusion. As an MSCI client, KraneShares, along with several dozen mutual fund families and institutional brokers, attended MSCI’s Index Review Seminar, which was held the morning after the announcement. MSCI’s message at the seminar was clear; investors need to proactively prepare for the coming changes.
We have two funds for investors looking to gain exposure to the onshore Chinese markets before inclusion begins:
The KraneShares Bosera MSCI China A ETF (ticker KBA) is the only U.S.-listed China A-share ETF to track an MSCI Index1: KBA holds the exact onshore Chinese securities that will be included into MSCI’s international indices.
The KraneShares FTSE Emerging Markets Plus ETF (ticker KEMP) KEMP offers exposure to the onshore markets as part of a broad emerging market strategy.
Changes like the one MSCI announced on June 9th are rare, but when they happen they have historically driven performance in the affected economies. For example, in 2012 MSCI announced that it would include the United Arab Emirates (UAE) in its emerging market index between 2012 and 2014; when the UAE’s inclusion was implemented, the MSCI United Arab Emirates IMI Index rose 238%2. This dwarfs the 130% rise the onshore Chinese markets have achieved since the rally began in the second quarter of 20143. We believe the onshore markets still have room to grow. Beyond MSCI’s decision, the recent surge in China’s onshore markets is backed by meticulous structural developments that have been decades in the making. We have listed a few examples of these developments below:
Raising Domestic Consumption
China’s policy makers are prioritizing increased domestic consumption in order to alleviate export dependency to the European Union and United States. Evidence of the policy’s success can be seen in China’s Year over Year retail sales data. According to China’s National Bureau of Statistics, retail sales in May increased 10.1% to $390 billion. The numbers indicate that China is catching up to well-established domestic markets like the United States. Additionally, the strong stock market has a trickle-down wealth effect on domestic consumption allowing Chinese investors to spend more freely.
Stock Investing Replaces Housing
China’s household savings rate is the third highest in the world at 51% of its GDP4. This rate is 300% higher than that of the United States5. Due to limited investment options in China, housing has traditionally been one of the most popular investment vehicles for Mainland Chinese citizens, which in return supported China’s urbanization policy. With housing softening, savings are finding a new home in the stock market. In fact, 4.4 million new onshore brokerage accounts have been opened by Chinese investors this year6.
Monetary Policy
China’s central bank has started to ease monetary policy. There have been two interest rate cuts and several adjustments to the reserve requirement ratio, which is the minimum amount of customer deposits that commercial banks must hold in reserve before making loans. The reserve requirement ratio was cut to 19.5% this year from 20% in 20147. More bank requirement cuts and targeted monetary policy are likely as policy makers continue to support growth. However, we do not believe that there will be more interest rate cuts because China’s leadership wants to keep the renminbi (RMB) stable ahead of the International Monetary Fund’s decision on the RMB’s inclusion into its basket of reserve currencies.
Unlocking Shareholder Value in State Owned Enterprise
Historically, China’s state owned enterprises (SOEs) have been undervalued compared to their privately owned counterparts. Unlocking shareholder value in state owned enterprises is a top policy in China today. This will take the form of increased mergers and acquisitions like the recent merger of China South Railroad with China North Railroad to form CRRC, one of the largest train manufacturers globally. Removing inefficiencies should raise the return on equity for State Owned Enterprises versus their private equivalents. We envision reform to heavily emphasize traditional sectors including industrials, basic materials and energy.
One Belt, One Road
Recently, China implemented the One Belt, One Road policy, which links Chinese manufacturers to Europe, Asia, Africa and the Middle East through improved overland transportation linkages and maritime port and logistic facilities. This spearheaded the launch of the Asia Infrastructure Investment Bank (AIIB) to help finance this policy.
Debt Deleveraging
China heavily restricted Initial Public Offerings and secondary offerings in the onshore markets for several years. Chinese companies had to rely on issuing debt to raise capital due to this limiting environment. The strong performance of the stock market allows new companies to list and for legacy companies to issue new shares. Proceeds can be used to pay down debt.
The MSCI decision overview
As the inclusion of the onshore market into MSCI broad indices has become a matter of when not if, China’s leadership is preparing its economy for massive inflows of foreign capital. Currently, China’s Securities Regulatory Commission (CSRC) is working with MSCI to address the three pending issues. The issues center around the programs China implemented in order to phase in the opening up of its economy. China has tightly regulated quota systems to allow foreign investors access to its onshore markets. The first program China launched was the Qualified Foreign Institutional Investor program (QFII), which gives specific foreign institutions access to the onshore markets. The second program to launch was the Renminbi Qualified Foreign Institutional Investor Program (RQFII), which is issued primarily to Chinese asset managers, and has been the catalyst for the launch of onshore China funds like the KraneShares Bosera MSCI China A Share ETF (ticker KBA).