With China set to dominate EM equity indices over the coming decades, investors need to adjust their approach to the asset class, argues Alistair Way.
2 minute read
In the early twentieth century, Japanese economists coined a theory of development known as the ‘flying geese paradigm’. The idea was that Japan led the way for neighbouring Asian economies, much as geese fly in a V-shape behind a single leader. The theory gained currency during Japan’s post-war economic miracle, which boosted regional trade and benefited other exporting nations.
However, by the time of its boom years during the late 1980s, Japan was flying so far ahead of other Asian nations that it was reasonable to question whether it should still be considered part of the flock. As Tokyo-based multinationals came to dominate global equity indices, investors sought to manage their Japanese exposure separately.
The same may soon be true of China. Over the last decade, China has soared ahead of Japan to become the world’s second-largest economy. Like Japan in the 20th century, China’s rapid growth and rapacious appetite for resources have transformed the fortunes of emerging markets – and, as with Japan, investors are starting to ponder whether China now requires standalone strategies.
Structural shifts
China has been central to the worldview of EM investors since its entry into the World Trade Organisation in 2001. According to research from the academics Francisco Costa, Jason Garred and João Pessoa, exports from low- and middle-income nations to China rose by a factor of 12 between 1995 and 2010, compared with a twofold increase in their exports to everywhere else.
But despite its transformation into a trading and manufacturing powerhouse, China took a long time to attract foreign capital flows commensurate with its vast size. Restrictions on foreign investment through the Qualified Foreign Institutional Investor (QFII) programme, coupled with inefficient domestic capital markets, proved a deterrent.
Now that is changing. The government is accelerating efforts to liberalise the financial system and bring in more foreign capital, and recent reforms have cleared the way for China’s entry into bond and equity indices.
Chinese large-cap A-shares (shares listed in mainland China) have featured in the MSCI Emerging Markets Index since mid-2018 and their weighting is being ramped up to over three per cent of the index in a two-stage rebalancing process in 2019. Add in H-shares (Chinese shares listed in Hong Kong) and China takes more than 30 per cent of the index.
Capital flows
The rebalancing is set to influence capital flows across emerging markets. As the MSCI index is tracked by more than US$2 trillion of active and passive funds, the rise in China’s weighting is likely to lead to outflows of US$40-55 billion from other emerging markets over the next six months, according to UBS.
A similar reallocation of fixed income capital is likely after China joins major bond indices. The Bloomberg Barclays Global Aggregate Index was the first of its kind to add China, launching a 20-month phasing-in period on April 1, 2019, while JPMorgan Chase & Co. and FTSE are also considering adding China to their fixed income indices. These inclusions could lead to over $200 billion of inflows into Chinese bonds, according to our estimates.
Japan’s experience in the 1980s offers pointers as to how investors are likely to respond to these shifts. At its peak in December 1988, Japan took a 44 per cent share of the MSCI World Index – more than double the country’s proportion of global GDP – as investors sought to tap into the success of multinationals such as Sony.
‘World ex-Japan’ equity portfolios gained prominence as investors sought to avoid concentration risk, which proved shrewd when Japan’s share of the MSCI index fell sharply in the 1990s after the bubble burst. By 1998, Japan’s weighting had fallen to less than 10 per cent of the index.
New indices, active strategies
While China’s growth path looks more sustainable, its rise is set to distort indices in a similar way – over the next few years, China could easily grab 40 per cent of the MSCI Emerging Markets Index. Investors will begin to question the logic of putting an increasingly powerful and affluent China into an investment bucket with much smaller and more volatile markets. Simply put, China is outgrowing its EM peers.
As this trend develops, we expect to see the emergence of new indices that group China with “EM” economies such as Taiwan and Korea – already developed markets in every respect apart from capital-market efficiency – much in the same way that the Europe, Australasia and Far East (EAFE) Index allows investors to cordon off their exposures to the US and Canada. Other, more-developed emerging markets from other regions, such as Poland and Chile, might also be candidates for inclusion in a separate index.
For active investors, China’s dominance will require dedicated strategies that dig into the nuances of its domestic market and take advantage of long-term structural growth trends, from the rise of “new retail” to the spread of mobile payments and other exciting digital technologies.
There is a debate as to whether the flying geese paradigm still holds true for Asian economies. But for investors who can adapt to its shifting relationship with other emerging markets and the rest of the world, China could still be the golden goose of diversified equity portfolios.
