Allocation d’actifs : 5 raisons de considérer la chine indépendamment des autres zones géographiques
- The accelerating integration of China into the world’s financial market will have a profound impact on how global investors allocate capital. While most agree that China is too big to ignore, there is no consensus yet among global investors on how to manage China exposure in their existing portfolio.
- This note outlines five reasons why investing in China as part of a homogenous emerging market (EM) portfolio is no longer appropriate given China’s economic size, financial market diversity, unique risk characteristics, fundamental differences to other EMs and the expected impact of its ongoing financial liberalization.
- These arguments make a strong case for investors to start considering China as a standalone asset class, similar to the US and Europe, where dedicated resources are devoted to managing the unique risks associated with the world’s second largest capital market.
China is too big to ignore
China’s meteoric rise since the late 1970s has been touted as one of the most striking developments in the world over the past half century. However, most of this rise has been associated with China’s economic achievements, while developments in its capital markets have generated less attention. This is despite the equally impressive growth in China’s equity and bond markets which has made them the world’s second largest today. However, because most of these markets were, until recently, closed to foreign investments, China was an “economic opportunity” difficult to convert to “capital-market gains”.
That situation has started to change in recent years. Not only have domestic reforms – such as interest rate and Initial Public Offering (IPO) liberalization – picked up apace, Beijing has also expedited the opening-up of its capital market via channels like the Stock and Bond Connects. Together with the inclusion of RMB assets into global indices, China has become a choice destination for global capital in the past few years.
So, with the world’s second largest market increasingly open for business, the question facing most investors is not whether they should invest in China, but how they should do it.
For the few early-movers – those who entered China via QFII and RQFII schemes – RMB assets are generally managed as part of an EM portfolio. Such a treatment makes sense to the extent that China, despite its aggregate size, is still an EM economy based on per-capita income, its capital market is as volatile as other EMs, and its policy and regulatory environment is still underdeveloped.
While many of these arguments are still valid today, we see an increasingly compelling case to separate China from other EMs and manage it as a standalone asset class. In the remainder of this note, we explain five reasons why global investors should devote dedicated resources to manage their China exposure.
#1: China has vast scale
For those who follow China closely, the size factor is obvious. China is the world’s second largest economy, accounting for 16% of global GDP in USD terms. However, on a purchasing price parity (PPP) basis, China was already the world’s largest economy since 2014 and made up almost one-fifth of global GDP last year (Exhibit 1). While China’s economic growth has slowed over the past decade, the incremental output added by its 6.6% growth last year was still larger than the full economic size of Australia.
While China is still behind the US in GDP size (in USD terms), it has surpassed the latter on a number of partial measures, including international trade, fixed asset investment, contribution to global growth, manufacturing value-added and total online consumption (Exhibit 2). To the extent that economic size matters for how global investors allocate capital, these measures suggest China is large enough to be considered as a standalone investment.
Besides the economic scale, China has grown its financial-market clout too. It was not so long ago that China was an under-capitalised economy before its equity and bond markets came to existence. Today, China is the world’s second largest market, with combined equity and bond market caps larger than those of the UK, France and Germany put together. Notably, China has achieved this with a still-low level of market-cap-to-GDP ratio (Exhibit 3). Should the latter continue its convergence to DM levels, ongoing financial deepening would fuel further growth in China’s capital markets.
#2: Chinese market is deep and diverse
Beneath the aggregate size, what investors also care about is the market depth and diversity. To be worthy of a standalone asset class, a market has to be well diversified to allow investors to spread risks and deep enough to enable an easy deployment of large capital.
Exhibit 4 compares the industry composition of the Shanghai Composite with those of the S&P 500 and Eurostoxx 50. The A-share index has the full 11 major sectors categorised by GICS, with a total of 1,519 listed companies. While financials and industrials make up a large portion of the market, their weights have declined over time as the economy rebalanced.
Liquidity conditions of the markets are also comparable to major developed markets (DMs). Exhibit 5 presents the trading volumes of the world’s five largest equity markets. While the absolute dollar transaction of China is lower than the US due to its smaller market size, China stands out with the highest turnover ratio thanks to the frequent trading of its retail investors.
Comparable information on the fixed income side is difficult to find globally, hence our analysis focuses narrowly on Asia. Exhibit 6 shows the ranking scores of bond market liquidity based on the turnover ratio, bid-ask spread and average transaction size. China ranks favourably in all three measures and is rated the overall most liquid market in the region. Overall, the analysis above suggests that China has comparable technical features to the world’s most liquid and diverse markets.
#3: China is fundamentally different to other EMs
One macro reason for why investors may want to manage multiple markets in a single portfolio is to capture the common trends among them. Grouping EMs in one asset class fits the bill, as these countries are at a similar stage of economic development and their markets are highly correlated. China, given its still-low level of per-capita income, has been lumped into a generic EM portfolio by many investors. But apart from that broad-brushed generalization, we argue that China actually has more differences than similarities to other EMs. These include:
- A different monetary policy cycle: EMs, as an asset class, are known for their sensitivity to the Fed’s policy (and hence movements of US interest rates and dollar). China, on the other hand, has a monetary policy more anchored around its domestic economy. In fact, China’s monetary policy cycle – proxied by the RRR movements – has been negatively correlated with that of the US over the past 15 years (Exhibit 7).
- Net commodity importer rather than exporter: Many EMs exhibit common business cycles in part because they are net commodity exporters. Resource-rich countries in Latin America, Middle-East and parts of Asia (e.g. Indonesia) fall into this category. China, on the other hand, is a net importer of commodities, meaning that the rise and fall of global commodity prices will have an opposite impact on it compared to others.
Low correlation of asset prices: Chinese asset markets are less correlated historically with peers thanks to the insulation provided by its closed capital account.
Exhibit 8 shows that adding Chinese equity and credit to global portfolios can lower total volatility and, in most cases, boost expected returns. Our portfolio simulation shows a consistent increase in the Sharpe Ratio upon a 10% allocation to RMB assets (Exhibit 8, right hand side chart). To the extent that part of this risk diversification is achieved by China’s controlled capital account, future liberalisation would likely erode this benefit. However, we expect this process to proceed slowly and be managed carefully by the Chinese authorities.
The above macro differences need to be assessed by global investors when they try to design the best strategy to investing in China. While managing it as part of an EM portfolio might have made sense in the past, we think such an approach has become increasingly obsolete as China grows into an asset class of its own.
#4: China’s unique risks require tailored solutions
Apart from the unique macro factors, investing in China can also expose global investors to policy and regulatory risks that are not commonly found elsewhere. Here are a few examples:
- Market regulations – particularly those concerning foreign investors’ access to the onshore markets. While these regulations have been relaxed considerably, the level of openness of the Chinese markets is still below those of major EMs. Future changes of Beijing’s liberalisation policies will likely continue to drive the scope of foreign investors’ activities in these markets.
- Macro policies which can influence the economy and markets, like they do elsewhere. However, China’s policy making is not only opaque, but different in many ways. For example, China’s monetary policy has multiple objectives – some of which, such as maintaining exchange rate stability and orderly balance of payments – are not common among other central banks and are what gives the People’s Bank of China (PBoC) a wider reach. To fulfil these goals, the central bank manages a large number of tools, ranging from interest rates and RRR to short-term liquidity facilities, all of which can significantly influence capital markets. Finally, the decision-making process is not transparent, with no pre-set announcement dates for monetary and fiscal policies. Understanding these idiosyncratic factors can be important for ensuring investment success in China.
- FX regime of the RMB, which is half-way between fixed and floating. While the PBoC has officially exited regular FX intervention, it still carries the discretion to step in if needed. This means that the FX market can switch across regimes – from those of market forces setting the price of RMB to those of market panics where the PBoC has to intervene to provide stability. While most EM authorities also manage FX to various degrees, the level and frequency of intervention have been higher in China and could remain so depending on the authorities’ commitment and delivery of future reforms.
- Market structure, which can determine the characteristics of China’s investment landscape. Like a typical EM, China’s equity market is dominated by retail investors, who tend to behave speculatively and prefer to invest in small-cap growth stocks. Both equities and bonds have onshore and offshore market splits, where prices of nearly-identical assets can vary significantly. Finally, international credit ratings are not yet available in the onshore bond market, whereas local ratings often lack credibility. Until the standards converge, foreign investors will have to rely on their own credit assessment.
The above discussion presents a mere subset of the unique policy and regulatory risks existed in China. These risks, in our view, can only be managed properly by a China expert with strong local knowledge and skills. An EM generalist who applies common risk factors to investing in the Chinese market will lead to suboptimal results, in our view.
#5: China’s financial open-up offers opportunities
Our previous report on China’s balance-of-payment transformation foreshadows a shift in the global financial system caused by the liberalization of the world’s second largest capital market. This process is intricately connected to how global investors view China as an investable market. Here is why:
First, China’s closed capital account has severely limited its integration in the global financial system over the past
decades. But that situation is changing by the gradual relaxation of capital controls that will make China an ever-larger share of the global asset market. The MSCI, for example, predicts that Chinese equities will make up almost half of its EM index once the full allocation is given to A-shares.
Second, the growth and liberalisation of the Chinese markets should create significant “active” opportunities for global investors. The internal rebalancing of the Chinese financial system should accompany a shift in household asset allocation, from properties to equities and bonds. Externally, continuation of China’s capital account liberalisation could trigger tens of trillions of in/out capital flows over time (Exhibit 9). These flows would change China’s financial landscape and create exciting opportunities for active investments.
Finally, a successful rise of the RMB as an international reserve currency could change the global monetary system. A shift – from a singular regime centred on the USD to a multi-polar system underpinned by the USD, EUR and RMB – would take time and require China to deliver further and substantial reforms. This process has already started in earnest, kicked off by global reserve managers allocating to RMB assets after the yuan was included in the IMF’s SDR basket. A continuation of this trend could strengthen China’s position in global markets and propel the yuan’s status as an international reserve currency.
 Qualified Foreign Institutional Investor scheme and RMB Qualified Foreign Institutional Investor scheme
 Global Industry Classification Standard
 Once combined with the Shenzhen Composite – the other major bourse in China – the sector weights of A-shares are more balanced.
 Liquidity underpinned by retail flows may not be considered as reliable as institutional liquidity for some investors.
 In China, retail flows account for almost 90% of daily trading volumes of A-shares, higher than most EMs.
 The latter can offer arbitrage opportunities as the market barriers are gradually removed.
 Yao, A. and Shen, S., (2019) “China: source of tectonic shifts in global finance” AXA IM Research & Strategy Insights, 10 September 2019
 For sure, such a process could only be achieved over the very long term and would require China to continue to carry out critical reforms.
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