Will China Export Volatility as Equity Markets Open?

China’s markets are opening to the world—but be aware of the potential for unintended consequences. As more money flows into domestic Chinese stocks from abroad, more money is also flowing out of China, which may trigger volatility in regional markets.

Global investors are eagerly anticipating increased access to Chinese onshore stocks, known as the A-share market. On May 31, index provider MSCI will include A-shares as about 0.35 percent of its emerging-market indices for the first time. At the end of August, the allocation is expected to double.

MSCI Takes Small Bites of A-Shares

MSCI is digesting A-shares in small bites. That’s because massive demand is expected as passive investors around the world purchase the stocks to bring portfolios in line with the new benchmark constitution. And purchases of A-shares are limited by capacity constraints, owing to strict Chinese quotas on how much foreign investors can buy every day.

Chinese authorities are doing their part to accommodate the changes. On May 1, they quadrupled the capacity of the Stock Connect trading programmes, which allow international investors to buy onshore stocks. But as China opens a wider door to foreign investors, it’s also allowing more money from Chinese investors to flow out of that door too.

Mainland Money Is Flowing to Hong Kong

The impact can already be seen in the H-shares market of Chinese stocks listed in Hong Kong. In recent months, flows of Chinese investments to Hong Kong have picked up dramatically (Display, left) for two main reasons. First, H-shares have been cheaper than A-shares since 2014 (Display, right). Given the opportunity, domestic Chinese investors will obviously prefer to own a cheaper stock in Hong Kong over its more expensive domestic A-share counterpart. Second, shares of big companies such as Tencent and various Macau casino groups simply aren’t available in the A-share market, so Chinese investors who want to own them have come to Hong Kong for those exposures.

Over time, this trend could affect the behaviour of the H-shares market. Domestic Chinese equity markets are very volatile—and inefficient—because they’re dominated by retail investors who own 86% of the market (Display). That’s more than double the proportion of retail investors in most major developed markets and Asian developing markets. In the US, retail investors haven’t dominated equity markets to such an extent since the 1960s.

Chinese Retail Investors Have Short Time Horizons

Chinese retail investors’ trading habits are fickle; they tend to act on news headlines and short-term developments rather than long-term forecasts. Even onshore mutual fund managers tend to behave like headline-chasing retail investors, because Chinese portfolio managers are typically incentivized to chase short-term performance.

For example, consider how the two markets reacted to the same news about China Unicom, a leading telecom group. On October 18, 2016, China Unicom warned that its annual earnings would drop sharply, although top-line growth driven by new 4G subscribers was strong. From that date until the end of the year, China Unicom H-shares fell 5.8%. But the A-shares of its parent company, China United Network Communications, surged more than 38% over the same period (even though China Unicom accounted for most of its earnings).

Why the difference? Investors in China Unicom H-shares focused on the negative implications for the company’s future earnings, as we would expect in developed markets. A-share investors quickly overlooked the weak bottom line and were assuaged by the company’s promises of corporate restructuring and the potential introduction of strategic investors and new management incentives. While these were all important developments, we think the share reaction may have reflected unrealistic short-term expectations over the potential impact of these changes.

Which Markets Will Be Next?

But Hong Kong is just the first step. Over the next three to five years, as Chinese liberalization unfolds, we think outflows from China will start to reach other markets—especially in nearby Asian countries. Large flows of Chinese retail money could alter the composition of the investor base in other markets and ultimately affect their behaviour. Relatively small markets like Taiwan, where only 37% of the market is comprised of retail investors today, could be changed dramatically.

Investors should pay close attention to the magnitude and direction of Chinese flows. China is already the world’s manufacturing export engine. It won’t happen overnight, but over time, China may add equity market volatility to the list of exports across the region and beyond.

The good news is that volatility creates opportunities for stockpickers, who can exploit market inefficiencies and mispricings to buy attractive stocks with unappreciated return potential. If Chinese volatility spreads beyond its borders, investors will need to be alert—and active—to navigate the risks and capture the opportunities.