While investors have, since the early 1990s, been able to access Chinese companies via overseas listings (namely Hong Kong), the domestic A-share market has been largely overlooked due to investability issues. Giving foreigners gradually greater access to the local A-share market has been a 15 year long process, which started in 2002 when China allowed a select number of institutional investors to invest directly into A-shares via the ‘qualification institutional investor’ (QFII) programme. Accessibility has since evolved, and most flows into the A-share equity market are now done via the ‘stock connect’, a bilateral loop linking the Hong Kong exchange with Shanghai and Shenzhen. 
The rise of the RMB
For policy makers, greater foreign participation in Renminbi (RMB) denominated investments - in this case, due to index inclusion - is part of a far grander ambition to make the RMB a truly global currency. In aiming to achieve this, policy makers have been very methodical in the way that they have gradually liberalised domestic interest rates, and steadily corrected capital market imbalances, to pave the way for a managed relaxation of capital account controls.
Performance of US dollar & sterling vs RMB over 1yr
Source: FE Analytics
Ultimately, as the breadth and depth of accessible investable RMB products like A-shares grow, so too should the power of the RMB rise.
Room for improvementWhile by August 2018 A-shares will be 0.73 per cent of the MSCI emerging market index, this is a limited amount for a market which accounts for around 21 per cent of world turnover and 10 per cent of world market cap. There is therefore plenty of scope for much greater inclusion going forward, although greater change would likely have to be accompanied by further market reforms by the Chinese regulator. Eventually, given the Chinese listed market cap is now second in size only to the US, and higher than the UK and Germany put together, what may happen is that China – much like Japan now – becomes far more dominated by country specific funds.
Good for stocks, but a need to be very selective
Historically, index inclusion announcements have supported a rally in stock prices as active managers buy shares in anticipation that more passive flows will follow. The most recent example of this is Pakistan, which, upon the announcement that it would be included the following year, rallied nearly 30 per cent over the following six months.
In the case of A-shares the impact on the broad market is likely to be less, as the limited weighting relative to market liquidity and size.
At a stock level however, there are likely to be a number of significant movements, as there is a meaningful difference in the types of investments foreign and local investors find attractive. Chinese investors are dominated by retail money, and typically chase after smaller firms with enough volatility to potentially make big gains quickly. International investors meanwhile, tend to have a far greater preference for larger cap businesses.
Performance of A-share indices over 1yr
Source: FE Analytics
The result of this disparity is that while smaller cap A-share companies are often excessively expensive, there are a number of very compelling larger cap opportunities, well positioned to do well from greater foreign flows.
Ultimately, MSCI’s decision is another positive move in the right direction for capital market reform for China. Greater institutional ownership of the domestic market should support lower return volatility and, at the company level, put pressure on corporate governance to improve.In our view, going forward future capital market reform in China will continue to create both significant risks and opportunities for corporates, creating an increasing divergence between those businesses challenged by change, and those able to benefit.
Charles Sunnucks is assistant fund manager at Jupiter Fund Management. The views expressed above are his own and should not be taken as investment advice.