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Can the world’s investors trust China’s wild stock markets?


Those eye-popping gains coincided with a fast run-up in all of China’s indexes, including the Shanghai Composite Index, which recently galloped into a bull market in just 32 trading days.

“I pay more attention to the stock market and business news now as the market sentiment has changed dramatically,” said Chen, who works for a state-owned logistics supply-chain company in Shanghai and has invested more than 100,000 yuan (US$14,900) in the stock market. “I am now keeping a close eye on the stocks I own and the sectors that are leading the market.”

Retail traders like Chen – and other quirkiness in China’s markets – have suddenly become a lot more important for investors from New York to London to understand.

That’s because a change is happening with lightning speed: Foreign money is piling into China’s markets, and much more is coming. MSCI – the leading global index compiler –

just quadrupled the representation of Chinese stocks

in its global gauges. Bloomberg will include yuan-denominated Chinese government bonds in a key global debt index in April.

And that means what happens in China no longer just stays in China.

But are China’s markets really ready for the coming wave of foreign investment?

That is the big, as yet unanswered, question.

Chen is one of China’s 148 million retail investors – the largest such stock-trading army in the world, and bigger than the membership of the Chinese Communist Party – and they are the faces behind why China’s stock markets are sometimes dubbed casinos.

These investors trade on hot news – and tips from the internet, barber shops or trading halls – and they are looking for very quick returns. These are not the tried and true buy-and-hold mutual fund owners of America, schooled in years of dire warnings not to ever, ever try to time the market.

China is already the world’s second-largest stock market, with capitalisations totalling US$7.2 trillion.

But nearly 80 per cent of annual trading is done by retail investors who are prone to chase rallies and pull out amid plunges.

The behaviour exacerbates roller-coaster rides on stock prices: In the past year, the Shanghai Composite Index, stuffed with stodgy state-owned blue chips, has seen four days with more 4 per cent plunges, versus none on the S&P 500. That includes the 4.4 per cent plunge on March 8.

In mature markets like in the US and Hong Kong, retail investors are just a small part of the action, with institutional investors accounting for about 80 per cent.

But China’s markets are a long way off from being what foreign investors would consider mature.

Stocks going down embarrassingly low at an inopportune time for Beijing? No problem. Just send in the so-called National Team – made up of big institutional investors – to buy up stocks to prop up the market. During China’s 2015 market meltdown, which wiped out US$5 trillion in market capitalisation, the state spent billions of yuan directly buying stocks to stem the losses, only to see shares fall to ever lower levels.

Meanwhile, companies seeking to float initial public offering (IPOs) are

required to cap prices at 23 times earnings

to ensure no flops, and first-day trading in IPO shares is subject to a daily cap set by the exchanges.

Some of the trading habits among local investors might also seem bizarre outside China. In January, stocks shot up whose names coincidentally contained the same Chinese characters as the name of the new head of China’s securities regulator, Yi Huiman. It was considered a lucky bet.

Aiming to tame speculative roller-coaster rides, the government puts a 10 per cent daily limit on gains or losses of individual shares.

And the government puts a cap on how much of a Chinese stock can be owned by foreigners. With all the money rushing in, a hot stock on March 7 was put off-limits to overseas buyers – and

MSCI booted it out of its global gauges

. Other stocks are closing in on the cap, which is set at between 28 per cent to 30 per cent, depending on how it is bought.

“The market is still subject to too much short-term noise,” said Andrew Mattock, a fund manager at Matthews Asia in San Francisco. “More institutional ownership of the market and professional long-term thinking of the investor base is still an issue, although it has become better.”

Some fund managers also express concern about the corporate governance – the operating rules for companies on everything from executive compensation to audits and handling of internal wrongdoing – of China’s listed companies.

Two cases highlight the concerns:

Leshi internet Information, once a bellwether in the small-cap index, was pushed to the verge of bankruptcy because of

unpaid debts by affiliates

. Meanwhile, Changsheng Bio-technology after being found to have forged data in vaccine production.

“At the stock level, corporate governance in China remains an area for scrutiny and selectivity,” said Rebecca Jiang, a fund manager at JPMorgan Asset Management in Hong Kong. “Governance is improving, but it remains uneven.”

In its announcement to expand China A share representation, MSCI said the country still has more to do. MSCI wants the Chinese authorities to add hedging tools and shorten settlement cycles for trades. Different trading holidays between mainland China and Hong Kong are disruptive to the Connect cross-border investment programmes for buying and selling by onshore and offshore investors, MSCI said. Meanwhile, it wants to allow so-called omnibus brokerage accounts to simplify stock trading.

Such changes will have to be made before it will add more Chinese shares, MSCI said, which in its latest move will account for 3.3 per cent of the weighting of the MSCI Emerging Markets Index by November.

Chinese authorities are already starting to tackle some of the shortcomings.

The securities regulator will fully normalise index futures trading and make it available to a wider array of foreign investors, according to Fang Xinghai, vice-chairman of the China Securities Regulatory Commission.

Even after three cuts in the required margins and transaction fees in index futures trading since 2017, the market remains far from active. It has only slowly recovered from the regulatory crackdown after the 2015 meltdown, which significantly raised trading costs and restricted the number of new contracts that can be opened every day.

Shorting on index futures contracts – betting that their prices would go down – was partially blamed by the regulator for the 2015 crash.

And on Monday, the Shanghai Securities News said China’s security watchdog will examine whether to lift foreign investors’ ownership limits on A-share stocks.Meanwhile, Hong Kong’s stock exchange operator also announced on Monday that it is

launching a MSCI China A Index futures

to act as a hedging tool for global investors trading A shares in Shanghai and Shenzhen through the northbound Connects.

Even with ongoing changes, many foreign investors consider China far from being an efficient market, meaning share prices do not fully reflect all the global market-moving news and sometimes even decouple from the rest of the world.

But that is also why some traders like this market so much. Trading on big swings – when a trader is right – can be hugely profitable.

“The A-share market has far lower correlation to global markets than MSCI China,” said Nicholas Yeo, head of China equities, at Aberdeen Standard Investments in Hong Kong. “It has different drivers and so tends to be less impacted by external events. As such, A-share exposure could bring valuable diversification benefits to a global portfolio.”

For some time, Chinese regulators have seen increasing institutional participation – including by foreign investors – as one of the best ways to tame the wild swings in China’s markets.

Now, their efforts are showing results.

Global fund managers held 1.15 trillion yuan worth of China’s yuan-traded stocks by the end of last year, according to the data from the central bank. That made up 2.6 per cent of China’s total market cap.

That was approaching the 1.68 trillion yuan total equity holdings by China’s mutual fund managers, the nation’s biggest chunk of institutional players. UBS Group predicts that overseas investors will probably eclipse local money managers as the most influential camp in the domestic market as early as this year, as MSCI’s weighting increase spurs a spike in foreign inflows.

Goldman Sachs says overseas investors may pour in US$70 billion into Chinese stocks this year after its weighting in the MSCI Emerging Markets Index increases, while Harvest Global Investments predicts as much as US$100 billion. HSBC Holdings says foreign buying may reach as much as US$600 billion in the next five to 10 years. The emerging-markets gauge is tracked by global assets totalling US$1.8 trillion, about a fifth of which are passively managed funds.

scmp Chinese start-ups worth at least US$1 billion in 2018 Source: Hurun Greater China Unicorn Index 2018. SCMP Graphics

“The implication is that there will be increasing allocation demand from global asset managers in the next few years,” said Michelle Qi, chief investment officer at Eastspring Investments. “We will see stronger pricing power of foreign investors at onshore market. Foreign investors’ investment thesis, research framework and stock pitching preferences have already had, and will continue to have a growing impact on A-share market going forward.”

Foreign funds’ names frequently appear on the lists of top shareholders of China’s blue-chip companies, including liquor-maker Kweichow Moutai and Gree Electric Appliances, one of the world’s largest air-conditioner manufacturers. Local investors even sometimes scour earnings reports

for foreign investors’ names for investment tips.

The road map to woo foreign investors has been long. Just before 2003, overseas traders were nowhere to be found in China’s markets, which were then off-limits to foreign trading. It was not until July 2003 that UBS rewrote the history, making the first purchase by foreign investors of Chinese stocks.

To make stocks more accessible to foreign investors, the authorities allowed the offshore yuan in share purchases and initiated the exchange link programme with Hong Kong, adding to the earlier qualified foreign institutional investor, or the QFII, programme that requires lengthy regulatory approvals.

After being rejected for three consecutive years, Chinese stocks eventually won a place in MSCI’s benchmarks in 2017. Authorities then scrapped the restrictions on foreign funds’ repatriations and lock-up period, issued rules to prevent protracted suspension among listed companies and quadrupled the exchange link’s daily quota available to buy stocks, making MSCI’s weighting increase a done deal.

Foreign investors are already being felt in China. They are believed to be one of the major pushes that stoked the more than 20 per cent rally this year, an unprecedented situation in a market that has been long dominated by domestic players in its near three-decade history.

Overseas traders spent 66.5 billion yuan buying Chinese stocks in February, the most for a single month since the exchange links with Hong Kong started in 2014.

“Regulators in China have taken market feedback on accessibility very positively and made changes in recent years to improve the local market structure, which we find very encouraging” said Thomas Taw, head of iShares investment strategy for Asia-Pacific at BlackRock. “We believe increased participation of international investors will make China’s capital markets ever more robust and provide new ways for all investors to support the country’s future growth.”



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