China: a decade of financial opening

Capital at risk. The value of investments and the income from them can fall as well as rise and are not guaranteed. Investors may not get back the amount originally invested.

Risk: Investments in China are subject to certain additional risks due to issues relating to liquidity and the repatriation of capital.

Until fairly recently, investing in China was a considerable challenge. The country’s domestic equity markets could only be accessed through strictly controlled quotas or through expensive derivative vehicles. Meanwhile, its fixed-income and private markets were almost entirely beyond the reach of foreign investors.

Over the past decade, however, China has steadily opened its financial markets. Initially, this liberalisation was relatively narrow. It began with an expansion of the quota systems and a relaxation of repatriation restrictions. But it has gradually widened so that international investors now have access to an enormous range of Chinese investments. This includes not only the domestic stock markets but fixed-income and private markets too.

Stock Connect

A crucial step in this journey was the creation of the Hong Kong–Shanghai and Hong Kong–Shenzhen Stock Connect schemes, in 2014 and 2016, respectively. These allowed international investors to access mainland Chinese markets much more smoothly and efficiently than previously. A Bond Connect scheme followed in 2017, affording investors direct access to China’s fixed-income markets for the first time.

In 2018, MSCI included the largest stocks listed on the Shanghai and Shenzhen stock exchanges – collectively, the A-share market – in its Emerging Markets Index. The included stocks rose from the top 5% of A-shares to the top 20% in 2019. As a result, China’s inclusion in investment benchmarks is starting to reflect its status as the world’s second-largest economy1 – and, on current projections, the world’s largest economy before the end of this decade.

Bumps in the road

China’s journey has not been entirely smooth, however. In 2015, for example, trading in shares was abruptly halted following a major market correction. And this year, the government made sweeping interventions in the technology and education sectors, leading to heavy sell-offs.

But despite these hiccups, the Chinese authorities have been consistent in pursuing their opening policy. For the most part, they have been slow and measured, certainly. And their interventions have undoubtedly been dramatic. But that in part reflects the lessons they learned from both the Asian financial crisis of 1997 and the Western financial crisis of 2008.

A structural underweight

A decade on from the start of this financial opening, however, most global investors are still underweight in China2. Part of this is caution about the country’s idiosyncrasies - most obviously, the risk of government intervention. Part of it, however, is structural.

It’s important to note that China is still underrepresented in the main equity indices3. All told, Chinese listed companies would probably make up more than half of a representative emerging-market index. But today, China represents only 34.7% of the MSCI EM benchmark4. So, with most emerging-market investors choosing to be around 5 percentage points underweight in China relative to the index, there’s a double underweight in operation.

Of course, investors do have some grounds for this caution. China is different. One of the biggest questions for investors is how to think about risk and return in a context in which the government has much more power to intervene in markets than in most other jurisdictions.

A wealth of opportunities

And not only is China big: it’s messy, too. In this continent-sized state, many different forces are at work. Take the environment, for example. Index providers report growing demand for Environmental, Social & Governance (ESG) factors and climate filters that allow people to look at the Chinese market through those lenses. On the one hand, the Chinese economy is heavily dependent on fossil fuels. But on the other, at least one arm of the state is deadly serious in driving the decarbonisation agenda. So there are opportunities for investors to capitalise on that even as coal plants are being fired up in Inner Mongolia.

That’s why investors should think of China not as a daunting monolith but as a whole series of different opportunity sets. Because of China’s sheer scale, each of those opportunity sets is vast. And the gradual liberalisation of the country’s markets, combined with their growing inclusion in benchmark indices, is making these opportunities more accessible to investors than ever before.

1IMF, April 2021
2MSCI, Peoples Bank of China, 30 September 2021
3MSCI, November 2021
4MSCI, November 2021