Latest Emerging Market Viewpoints
From Matt Linsey and the North of South Capital team
China currently accounts for over 30% of the benchmark market capitalisation of the MSCI Global Emerging Market index. At this level China now represents a higher percentage of the index than any individual country has in the past.
If Taiwan and South Korea get promoted to developed market status and with the domestic China A shares gradually being included in the index (with another increase in their weighting in the index next month), there is a good chance that China’s weighting could exceed 50% of the total market capitalisation of our asset class in the next few years.
If this were to happen the performance of most Global Emerging market funds would be primarily driven by their allocation and stock selection in China. It would be surprising if this were allowed to happen by the relevant index providers.
Our expectation is that over the next five years given the size of the Chinese equity market that it will become its own asset class, similar to that of Japan, Europe and the United States. One of the key drivers behind this will be the movement toward full convertibility of the currency and the elimination of all barriers to foreign investment in the market.
A more freely tradeable currency would enable China to avoid the accusation, primarily but not exclusively by the U.S. of being a currency manipulator. It would also enable the authorities at some point to engage in the quantitative easing (essentially money printing) used by most Developed Market Central Banks over the past few year.
Another driver behind this move will the inclusion of the domestic Renminbi bond market, already the third largest in the world, in the relevant bond indices. Despite having the third largest bond market in the world, China accounts for less than 1.0% of the Bloomberg Barclays Government debt index. Although this will increase to approximately 6.0% next year, this still represents a small percentage of what we believe will be its ultimate weighting in most bond indexes.
From an investment perspective there a number of implications. Firstly, it will be very difficult to predict at what point MSCI determines that China’s equity market is large enough to be considered an asset class in its own right. They would obviously meet an enormous amount of resistance from emerging market equity funds facing the prospect in the future of potentially having to liquidate what could potentially be almost half of their assets? The longer they wait the more turmoil this decision will ultimately cause.
Secondly, from the Chinese perspective moving toward convertibility and making the renminbi a reserve currency would at some point require severely limiting the private sectors ability to borrow in U.S. dollars. A freely floating currency and large amount of foreign debt held by the private sector is a potential recipe for disaster. Last year along U.S. dollar borrowing by domestic Chinese companies totalled more than U.S. $ 50 billion, more than double the previous year.
As a precursor to any decision by the Chinese authorities to move towards convertibility we would expect a move to further open up the domestic bond market for overseas borrowers. This could potentially be a very positive catalyst for the real estate sector, particularly if it occurs at the same time China’s weighting is increased in global bond markets, creating a willing group of potential buyers.
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