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De-mystifying the HK / China Index Landscape

China's USD 12-trillion stock market is a vast and complicated panoply of different share types across a wide variety of markets, exchanges and share classes. With the rising role of A-shares amongst international emerging markets (EM) indices, understanding the market dynamics of China's equity markets will be increasingly critical, as Chinese equities are set to become an increasing proportion of the global opportunity set, driven by their increasing role in EM equities. Deutsche Bank’s research team looks at the distinguishing features of China's onshore and offshore markets.

China in the driver’s seat

One of our core long-term themes in the region is the rising importance of Chinese capital markets liberalisation. China's role in regional, and eventually global markets, will continue to rise in importance, both through the increasing component of A-shares, the centrality of China as an economy and the growing impact of Chinese capital. This will increasingly put Chinese positioning, flow, and sentiment in the driver's seat of regional returns.

China has QE levels of household savings. As this CNY 76 trillion capital moves throughout the region, it will play an increasingly larger role in market returns, correlation and trading dynamics. This is something we are already seeing in the outsized impact that Stock Connect is having on the Hong Kong market. This year, MSCI and FTSE have made moves to dramatically increase the weight of A-shares (and thus Chinese stocks) in their suite of EM indices, to the tune of 20% and 25% inclusion factors, respectively.

Chinese stocks are on a path to dominate global EM indices. We estimate China will account for around 43% of MSCI EM at full inclusion (based on current relative market capitalizations). These benchmark shifts should further accelerate the rising importance of China: it will be increasingly critical for Asia- and EM focused investors to understand the role that China sentiment has on their equity markets.

Hedging considerations - critical to the China investment process

Given the wide range of exposures we see across Chinese indices, share classes and listing locations, hedging choice in China is of critical importance. This is further complicated by significant access issues, especially as it relates to the A-share market, where futures access is limited and shorting at the single stock level is hard to access and often difficult / expensive to borrow.

Our experience suggests there is no "one-size fits all" China hedging strategy. Listing venue, sector mix and factor exposure will be key determinants of the "best hedge". We recommend investors look at bespoke optimised hedging solutions, whether they be futures / ETF-based or using custom basket hedge portfolios.

Access availability, borrow / roll costs and financing considerations change quickly in Chinese markets. At the same time, we continue to see ongoing liberalisation which should open up more access to A-share hedging products and single stock short inventory.

The Stock Connect programmne has greatly increased the availability of single stock A-share shorts; the recent announcement from MSCI and HKEx, that they will launch a futures contract on MSCI China A should add further hedging flexibility. Amidst the current period of heightened volatility, understanding the full menu of tools in China is critical given the significant dispersion of performance and risk across indices.

Hedging A-share portfolios has historically been difficult for global investors, but we are optimistic that with further liberalization, an increasing pool of Connect inventory and the introduction of additional offshore hedging instruments, the menu of hedging options for A-shares will continue to increase.

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