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.