Analysis of Potential Inclusion of Chinese Bonds and A‑Shares in Major Global Indexes

The most influential global bond index is believed to be the Citibank World Government Bond Index (Citi WGBI), which is used as the benchmark for more than $2tn of AUM. The most influential EM bond index is the JPM Government Bond Index — Emerging markets Global/Diversified (JPM GBI-EM Global/Diversified), which is used as the benchmark for about $200bn AUM and caps each country’s share to 10%. A caveat, however, is that the actual size of indexed money or ETFs should be smaller. The most crucial country criteria of Citi WGBI is “fully accessible to foreign investors,” which makes China less likely to be included by far given its accessibility to only medium- and long-term investors. Even if China is being considered, the assessment usually takes a long time. So we believe the case for China to be included into Citi WGBI in 2017 is unlikely. By contrast, JPM GBI-EM Global/Diversified only requires accessibility to the majority of foreign investors and does not factor in tax hurdles in eligibility. We believe China has better chance to be included into the JPM GBI-EM Global/Diversified index. While the exact timing is hard to predict, an optimistic scenario possibly leaves 2H17 on the table. Usually when a big country is being included, bonds are introduced slowly over many months to enable clients to rotate without too much disruption. We would expect China’s inclusion to account for 10% of the JPM GBI-EM Global Diversified index. Turkey, Malaysia, S. Africa, and Thailand would lose the largest shares in the index, while the shares of Brazil, Mexico, Poland and Indonesia are expected to remain given their large absolute size. Inflows to China could be around $20bn, or equivalent to 1.5% of the aggregate central government bond market cap. Turkey, Malaysia, S. Africa, Thailand and Columbia could see outflows of $2.4bn-3.3bn each, with the most expected impact on Thailand given its lower relative foreign ownership. We would expect China to account for 4.4% of the Citi WGBI index. The biggest losers of market share will be the US, followed by Japan and Europe. Inflows to China could be around $87bn, or 6.5% of its CGB market cap. This would present a very bullish scenario for CGBs, and the curve will likely steepen. MSCI inclusion - more about good will, then real flow Another potential implication of China capital account opening is equity inflows. The MSCI has been considering the inclusion of China A-shares in its index. These are shares of local Chinese companies trading at the Shanghai and Shenzhen stock exchange, whose trading is so far limited to local investors (China: Will A-shares be included in MSCI in June this year?). The associated flows aren’t likely to be too large, so positive price reaction is likely to come mostly from sentiment. The MSCI has discussed most recently a 5% inclusion factor for A-shares, which would translate in an additional 1.1% MSCI weight of China in the index. The scope for additional foreign capital looks small, when considering that China already weighs 27% in the index. Our equity strategists estimate the total AUM tracking MSCI EM to approximately USD1.6tn (total market cap of the index is USD3.8tn}, so that inflows upon inclusion would be roughly USD16bn. The inclusion was delayed in June 2016, mainly due to obstacles regarding the quota allocation process, capital mobility restrictions and beneficial ownership. Chart 60: Estimated loss of share if China is included in JPM GBI-EM Chart 61: Estimated loss of share if China is included into Citi WGBI Global Diversified 0.0% Oy 0 Oy 0) 0.0% 0.0760.0% 0.0% 0.0% -0.19%0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% -0.1%9-0% -0.5% 03% -0.5% 0.3% tes 1.0% ill 0 109 1 -0.9%0.9% -1.5% 1.5% 4.3%) 2% 4 poy! 5% 1.5% 2.0% whe “£L, 0 Oh EPR HBR EBERLE RRL Aare Soozeyrzyan x BEPSESRES22SHES SSG6S2S5656803N2 Source: BofA Merrill Lynch Global Research Source: BofA Merrill Lynch Global Research Bankof America Merrill Lynch Global Rates, FX & EM 2017 Year Ahead | 16 November 2016 35 HOUSE_OVERSIGHT_014765