Once MSCI’s two-phase inclusion of 14 US-listed Chinese companies into its China and emerging market (EM) indices is completed in May, China’s ‘new economy’ sectors are set to comprise nearly 40% of the MSCI China index, making it a better proxy of China’s future growth engine. Weightings of Indian, Taiwanese and South Korean stocks will fall to make way for the inclusion of the 14 companies in the MSCI Emerging Markets index.
In October last year, MSCI released the details of the latest revisions to its emerging market, regional and country indices, confirming the inclusion of 14 China ADRs (American Depositary Receipts) – US-listed Chinese companies. The integration of these companies into the index will occur in two stages, with half of the free-float market capitalisation of the new constituents added with effect 1 December 2015 and the other half taking effect on 1 June 2016.
Exhibit 1: China ADRs to be included in the MSCI Emerging Markets index
As the 14 new entrants are all Chinese companies, the change will obviously have the greatest impact on the MSCI China index. And because nearly all of the companies are tech and consumer firms, the estimated index weight of the technology sector could more than double to over 28% from 14% after the second phase of rebalancing by 1 June 2016. The knock-on effect of this is that the weight of the financials, telecommunications services, industrials and energy sectors will shrink significantly. Financials will fall from 40% to roughly one-third of the overall MSCI China weight.
Exhibit 2: Pro-forma sector weight of MSCI China (%)
In essence, the index weight representing the consumer and services-led ‘new economy’ in the MSCI China index will rise to around 40% from just 26% prior to the November 2015 rebalancing. In our view, this is a timely change. Challenged by rising domestic wages and moderating global external demand, China has been forced to address the tough task of rebalancing the economy by bringing forward reforms to upgrade its value chain and gear the country’s GDP more towards consumption and services. This is why we see the newly constituted MSCI China index as offering a better representation of China’s future engines of growth.
Exhibit 3: MSCI China index post 1 June 2016: a better proxy for China's 'new economy'
Source: MSCI, FactSet, Goldman Sachs research, November 2015
But perhaps a sting in the tail for other Asian stocks
With the additional China ADRs included, the MSCI Asia Pacific ex-Japan index will see China’s country weight increase from 22% to roughly 26%. And China – already the biggest country in the USD 3.5 trillion market cap MSCI Emerging Markets index – will see its weight rise in that benchmark from 25% to around 29%. Clearly, something else has to give way to make room for the Middle Kingdom. The countries whose allocations in the MSCI EM index are most likely to be squeezed the most via the rebalancing are South Korea, Taiwan and India as – prior to the index adjustment in December – theirs were the highest individual country weights after China’s, at about 16%, 12% and 8% respectively. As journalist Nyshka Chandran put it: “Around USD 7 billion could move into these China ADRs as passive funds that track the MSCI index snap up the assets. Because these funds mimic the index, investors are likely to rebalance their portfolios to match the new weightings, which could result in the ‘crowding out’ of other markets.”