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Prevailing Winds

The China Investment Dilemma – Part I

China’s Financial Rise

Prevailing Winds is a China-focused blog written by Nicholas Borst, Director of China Research at Seafarer. The blog tracks the economic and financial developments shaping the world’s largest emerging market.

Driven by the growth of its economy and capital markets, China is rapidly emerging as a major investment destination for global investors. The country has experienced a dramatic rise in foreign investment inflows, and its weight in global bond and stock indices is increasing. Americans now own hundreds of billions of dollars of Chinese securities, and China is one of the largest single-country exposures for U.S. investors.

This moment ought to be a triumphant one for both China’s capital markets and U.S. investors seeking greater exposure to the country’s economic success. Instead, investing in China has become more fraught than ever, as a result of the deteriorating relationship between China and the U.S. The growing economic and security tensions between the two countries have spilled over to the equity markets, with deleterious consequences for a wide swathe of companies. Now as the Covid-19 pandemic buffets global financial markets, both countries seem more interested in assigning blame than working together to address the crisis. Navigating the risks and opportunities of investing in China will be one of the most important challenges facing globally minded U.S. investors for years to come.

China’s economic ascent is one of the most important events shaping investing in the 21st century. China is now the world’s second-largest economy and the main source of global economic growth, having contributed about 28% of the world’s growth on average since 2010.1 What has been less well appreciated is China’s emergence as a financial superpower, driven by the size and increasing openness of its capital markets.

Globally Important Capital Markets

In the span of just a few decades, China’s equity markets have grown to become among the largest in the world. As shown in Figure 1, the Shanghai and Shenzhen stock markets have a combined market capitalization of about 8.5 trillion USD-equivalent, making China the world’s second-largest national equity market after the U.S. Together, the Shanghai and Shenzhen markets are now similar in size to the combined market capitalization of the London Stock Exchange and the Euronext exchanges.2 Chinese companies listed on the Hong Kong exchange add another 2.9 trillion USD-equivalent to the total market capitalization of Chinese companies. The combined market capitalization of all listed Chinese companies – companies listed domestically and on overseas exchanges – exceeds 12 trillion USD-equivalent.

Figure 1. Market Capitalization of Chinese Companies
Sources: Wind Information, Thomson Reuters, UBS.

This increase in stock market capitalization has been driven both by the listing of new companies and the expansion of existing Chinese companies into some of the largest corporations in the world. Over the past decade, China led the world in initial public offerings (IPO), as more than 2,500 Chinese companies went public, more than twice as many as in the U.S.3 During this period, IPOs of Chinese companies raised more money than IPOs in the rest of Asia combined (Figure 2).3

Figure 2. Proceeds from IPOs by Company Home Jurisdiction
Annual amounts are in 2018 USD Billions.
Source: Organization for Economic Cooperation and Development (OECD).

China is now home to some of the world’s largest listed companies. China accounts for the second-largest share of the world’s top 100 companies by market capitalization, after the U.S.4 China’s largest companies include a mix of private sector tech giants, such as Alibaba and Tencent, and state-owned firms, such as the Industrial and Commercial Bank of China (ICBC) and the China Construction Bank.

Beyond mere size, China has significant corporate depth. One way to quantify corporate depth is to look at the number of listed companies a country has in a given sector. Figure 3 shows the results of this exercise when applied to the MSCI ACWI Investable Market Index (IMI), which includes more than 8,000 companies and is representative of a very broad investment universe. (To screen out the potentially large numbers of very small companies, a threshold of 500 million USD market capitalization was used for inclusion.)

Figure 3. Top 10 Countries by Number of Listed Companies with Market Cap > $500MM
Communication Services Consumer Discretionary Consumer Staples Energy Financials Health Care Industrials Information Technology Materials Real Estate Utilities Total
United States 95 255 95 109 380 330 330 304 112 174 67 2251
Japan 48 187 100 10 88 69 269 133 96 77 18 1095
China 43 94 50 26 108 89 142 96 89 61 33 831
United Kingdom 21 57 26 11 46 18 61 22 17 34 10 323
Taiwan 6 33 11 1 31 9 29 126 31 10 1 288
South Korea 16 45 30 3 30 39 51 31 30 2 277
India 11 38 15 10 46 23 37 13 38 9 13 253
Canada 10 17 9 35 32 8 31 11 51 28 16 248
Australia 8 26 14 12 28 15 21 15 41 23 4 207
Germany 11 23 6 2 16 18 40 17 18 16 5 172
The investment universe is constituents of the MSCI ACWI Investable Market Index (IMI) with a market capitalization threshold of $500 million and above.
Sources: Bloomberg, MSCI, Seafarer.

No other emerging market comes close to China in terms of having companies of all sizes in all major industries. Even among advanced economies, only the U.S. and Japan have greater corporate depth than China. The breadth and depth of listed companies reflects the size and diversity of the Chinese economy. China’s equity markets are newer than markets in the other countries in Figure 3. As China’s equity markets continue to develop, the level of corporate depth will increase even further.

China’s bond markets have also grown, in both size and prominence. Its bond market (government and corporate) is the world’s second-largest, having recently surpassed that of Japan.5 Its corporate bond market is the world’s second-largest; it is roughly half the size of the world’s largest bond market, the U.S.5 Chinese sovereign debt is increasingly held by central banks as foreign exchange reserves, following inclusion of the renminbi (RMB) in the International Monetary Fund’s Special Drawing Rights basket, in 2016. Though far behind the dollar and the euro, global foreign exchange reserves of renminbi assets now exceed 200 billion USD-equivalent.6 Total holdings by foreign investors of Chinese renminbi-denominated bonds are now worth about 300 billion USD.7

Increasingly Open Capital Markets

Until recently, China’s capital markets were difficult for foreign investors to access, requiring a lengthy registration process and subject to a quota under the Qualified Foreign Institutional Investor (QFII) program. Although China’s capital account still remains closed for many financial flows, portfolio investment has become easier over the past several years, thanks to a spate of new capital account reforms.

The creation of Stock Connect is the most important reform affecting China’s stock markets. Established in 2014, with a link between the Shanghai and Hong Kong stock exchanges, it provides foreign investors with access to most of China’s domestic equity markets, as measured by market capitalization. In 2016, a similar link was created between the Shenzhen and Hong Kong exchanges. Via the Stock Connect programs, a foreign investor with a brokerage account in Hong Kong can purchase stocks of domestically listed Chinese companies without needing to register with mainland authorities. China has scrapped the total aggregate quota for the program that was initially in place. Stock Connect still has a daily quota, but it has been expanded significantly since launch and has never been fully utilized, despite significant uptake by foreign investors.8 By the end of 2019, the value of net foreign inflows via Stock Connect reached nearly 1 trillion RMB (143 billion USD), as shown in Figure 4.

Figure 4. China Stock Connect Accumulated Net Inflows
Includes the Shanghai-Hong Kong Stock Connect and Shenzhen-Hong Kong Stock Connect.
Sources: Wind Information, Seafarer.

Investing in China’s bond market has also become more accessible to foreign investors. Starting in 2015, foreign central banks, sovereign wealth funds, and institutional investors were given direct access to China’s interbank bond market, which accounts for 90% of total bond volume.9 Another major opening of the bond market occurred in 2017, with the creation of the Bond Connect program. Like Stock Connect, it allows foreign investors with brokerage accounts in Hong Kong to buy and sell mainland Chinese bonds via a streamlined registration process. As of September 2019, more than 1,300 institutional investors had enrolled in the Bond Connect program. Average daily turnover was about 15 billion RMB.10

China recently reformed the QFII program, the original method by which foreign investors could access China, to make it more attractive. The program had been hamstrung by an arduous registration process, long lock-up periods for invested funds, quotas, and restrictions on the frequency of redemptions. Most of these concerns have now been addressed, with the elimination of the initial lock-up periods, allowance of daily redemption, and removal of the 20% monthly redemptions cap and the quota system.1112

Growing Weight in Global Indices and Investor Portfolios

As China’s capital markets have expanded and become more open, the country’s weighting in global investment indices and investors’ portfolios has increased. In 2017, MSCI, a major global index provider, announced that Chinese A-shares would be included for the first time in its emerging markets index. This change generated headlines and was matched by actions of other index providers, including FTSE Russell and S&P Dow Jones, to include A-shares in their indices.

China now accounts for 34% of the MSCI Emerging Markets Index. Because of MSCI’s methodology, the majority of China’s weighting is based on Chinese companies listed in overseas markets, such as Hong Kong and New York; domestic A-shares account for just 4% of the index. This weighting is set to increase over time, however, as China further reforms its domestic stock markets.13 If Chinese A-shares reach a 100% inclusion rate (the current weighting is 20%), China will account for 43% of the index, equivalent to the next seven countries (South Korea, Taiwan, India, Brazil, South Africa, Russia, and Mexico) combined (Figure 5).

Figure 5. MSCI Emerging Markets Index Country Weightings Potential 100% Inclusion of Chinese A-Shares
Sources: Goldman Sachs, Seafarer.14

A similar trend has occurred with China’s inclusion in global bond market indices. China was added to the Bloomberg Barclays Global Aggregate Bond Index in 2019, and JP Morgan announced that China will be included in its Government Bond Index – Emerging Markets in 2020. As with the equity indices, the initial weighting of onshore bonds is low relative to the size of the market but is expected to grow over time. The FTSE is the only major index provider that has yet to include Chinese onshore bonds in its indices.

Based on an estimate of holdings of Chinese companies listed domestically and on foreign exchanges, U.S. investors own more than 500 billion USD worth of Chinese securities, making China the fourth-largest foreign exposure for U.S. investors, falling just behind France. As China’s weighting in global investment indices increases, the share of China holdings for passive investors will increase. Active investors have more flexibility regarding their level of China exposure, but many have chosen to invest an even larger share of their portfolios in Chinese securities compared with the indices because of the country’s economic and financial importance.

Just as China becomes a more economically important and in many ways compelling part of some U.S. investors’ portfolios, a new set of political and economic risks have emerged that threaten to curtail the benefits these investors might expect. Part II of this paper looks at the rocky state of the U.S.-China relationship.

Nicholas Borst,
MSCI All Country World Index (ACWI) Investable Market Index (IMI), Net Total Return USD is an all-capitalization index designed to represent the equity investment opportunity set in developed and emerging markets. Index code: M1WDIM. The MSCI Emerging Markets Index is a free float-adjusted market capitalization index designed to measure equity market performance of emerging markets. Index code: MXEF. The Bloomberg Barclays Global Aggregate Bond Index is an index of global investment grade debt securities from local currency markets. This multi-currency benchmark includes treasury, government-related, corporate and securitized fixed-rate bonds from both developed and emerging markets issuers. Index code: LEGATRUU. The J.P. Morgan Government Bond Index – Emerging Markets (Local Currency) is an index of local currency bonds issued by emerging market countries. Index code: GBI-EM. It is not possible to invest directly in an index.
As of December 31, 2019, Alibaba Group Holding, Ltd. comprised 4.8% of the Seafarer Overseas Growth and Income Fund. As of December 31, 2019, the Seafarer Funds did not own shares in the other securities referenced in this commentary. View the Top 10 Holdings of the Seafarer Overseas Growth and Income Fund. View the Top 10 Holdings of the Seafarer Overseas Value Fund. Holdings are subject to change.
The views and information discussed in this commentary are as of the date of publication, are subject to change, and may not reflect Seafarer’s current views. The views expressed represent an assessment of market conditions at a specific point in time, are opinions only and should not be relied upon as investment advice regarding a particular investment or markets in general. Such information does not constitute a recommendation to buy or sell specific securities or investment vehicles. It should not be assumed that any investment will be profitable or will equal the performance of the portfolios or any securities or any sectors mentioned herein. The subject matter contained herein has been derived from several sources believed to be reliable and accurate at the time of compilation. Seafarer does not accept any liability for losses either direct or consequential caused by the use of this information.
  1. Author’s calculations based on figures on current price gross domestic product (GDP) from the International Monetary Fund’s October 2019 World Economic Outlook. Data for 2019 are based off estimates.
  2. World Federation of Exchanges, Statistics Portal, accessed 30 January 2020.
  3. Organization for Economic Cooperation and Development, OECD Equity Market Review Asia 2019. November 2019.
  4. PWC, “Global Top 100 Companies by Market Capitalisation,” July 2019.
  5. Asian Development Bank, “Asia Bond Monitor,” September 2019.
  6. International Monetary Fund, “Currency Composition of Official Foreign Exchange Reserves,” 30 September 2019.
  7. Bond Connect, “Market Data,” October 2019.
  8. The quota for Stock Connect is calculated on a net buy basis, meaning that sell orders are subtracted from the usage of the quota.
  9. Nicholas Borst, “China’s Bond Market: Larger, More Open, and Riskier,” Federal Reserve Bank of San Francisco, 20 May 2016.
  10. Bond Connect, “Bond Connect Continues to See Strong Momentum in September,” September 2019.
  11. Asia Securities Industry and Financial Markets Association, “Foreign Institutional Investment in China: An Asset Management Perspective,” March 2019.
  12. “Economic Watch: China Lifts Investment Quota Limit for QFII, RQFII amid Financial Opening-Up,” Xinhua, 11 September 2019.
  13. Officials at MSCI have indicated that China would need to implement several additional reforms before it would increase the level of inclusion. They include providing onshore hedging and derivatives instruments, addressing investor concerns about China’s short settlement cycle, aligning holidays between onshore markets and Stock Connect, and creating an omnibus trading mechanism. See “MSCI Completes the Successful Implementation of Final Phase of the 20% Partial Inclusion of China A Shares in MSCI Indices,” 26 November 2019.
  14. Kinger Lau, Timothy Moe, Jack Wang, and Si Fu, “China Weekly Kickstart,” Goldman Sachs, 8 November 2019.