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On 20 June, the MSCI announced the results of its annual market classification review. As expected, mainland China has been reclassified and will enter the emerging markets indices in 2018. We look at what this decision means, both for investors and the global financial ecosystem.

As we suggested would be the case, the MSCI has announced that mainland Chinese shares will join its emerging markets indices for the first time next year. While the initial decision is limited to a small section of shares, this starts the process for broader inclusion of mainland Chinese shares, one of the world’s largest stock markets by size.

The main takeaways

The results of MSCI’s annual reclassification review have been announced, and mainland Chinese shares will join the wider emerging markets indices for the first time from 2018. Initially, just 222 stocks will be included – larger, more liquid stocks that are more accessible to overseas investors – at only a 5% inclusion factor, meaning the total weight of mainland shares in the index will rise to just 0.73%.

While this seems a relatively small adjustment to current weightings, the decision marks a step change in global investors’ perceptions of the mainland market, and is indicative of the beginning of wider acceptance of onshore Chinese financial markets into the global financial ecosystem.

However, many barriers remain to higher inclusion, most critically the accessibility of markets to overseas investors and structural market issues such as stock suspensions.

Why does the onshore Chinese stock market matter?

The mainland Chinese stock market is one of the world’s largest by size (second only to the USA) and contains over 3,000 companies, yet remains almost entirely domestically owned, with overseas investors accounting for a small proportion of the overall market.

In the long term, the impact of mainland Chinese stocks joining the emerging markets would be significant for investors, as the investment universe for emerging markets shifts to be more China oriented. In fact, while Chinese companies (those based in Hong Kong or overseas) currently account for approximately 28% of the emerging markets indices, this would rise to an estimated 40% if all mainland stocks were considered for inclusion.

The mainland market is also the domain of many domestic companies highly integrated into China’s rapidly growing consumer and service industries, perceived by many market participants as the future for the Chinese economy as it attempts to move away from its industrial and export-based foundations.

Unique challenges

The onshore market also has its unique challenges for investors. Accessing the market itself has been historically challenging for outside investors, with access traditionally restricted to investors who had applied for schemes that allowed them to purchase a limited value of shares. However, the Chinese authorities have made significant progress in recent years towards enabling greater access for overseas investors – including the launch of stock connect, an initiative that allows the trading of some mainland stocks from Hong Kong.

Other unique challenges relate to market structure, including: the composition of investors (retail investors make up a much higher percentage of the market), state support for the market, the daily trading limits imposed, and the unusually high level of stock suspensions.

What happens now?

Starting May 2018, the first mainland Chinese shares will enter the MSCI emerging markets indices, and investment managers will begin to adjust their portfolios accordingly.

Any further integration of mainland Chinese shares into the indices will depend on further alignment of market standards, and the Chinese authorities continuing to improve access channels to onshore markets. Any further inclusion could mean a wider universe of stocks becoming eligible, or the inclusion factor being raised from 5%.

One thing is certain: while yesterday’s announcement marked the start of the process of inclusion, the path to full inclusion will be a long one.

Risk warning

As with all investing, your capital is at risk. The value of your portfolio with Nutmeg can go down as well as up and you may get back less than you invest. Past or future performance indicators are not a reliable indicator of future performance.