Are China’s A-shares the next big thing?

Leslie Shaffer | Writer for
Brent Lewin | Bloomberg | Getty Images

China's domestically listed stocks, or A-shares, have barely budged for the past few years, but a combination of debt-default concerns and reform measures may spur the market higher.

"China's A-share market is becoming, quite simply, too big to ignore," HSBC said in a note, citing planned sweeping reforms which include allowing more foreign funds into a stock market still largely closed to overseas investors.

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Liberalizing the capital account to allow more foreign investment in the market would be a "game changer," HSBC said. It noted MSCI is considering including A-shares in its emerging markets index, with a final decision set for June.

With around $1.5 trillion benchmarked to the MSCI Emerging Market Index, inclusion could send billions flowing into A-share markets, HSBC said.

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More than 2,500 companies are listed on the Shanghai and Shenzhen exchanges for a combined market capitalization of $4 trillion, the fifth largest globally, with their combined average monthly trading volume at around $632 billion, third globally behind NYSE and Nasdaq, it noted.

HSBC projects the two markets' combined capitalization will grow to $10 trillion by 2020, for a 14 percent compound annual growth rate. It expects foreign participation could reach at least 10 percent of the market by 2020, or around $1 trillion, compared with only 3 percent currently under a quota system.

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"This is conservative, given the high household savings rate and the fact that stocks represent only 40 percent of financing in China, far below the 70 percent for most developed economies," HSBC said.

China's household savings had reached around 45 trillion yuan (around $7.27 trillion) at the end of 2013, nearly twice the size of the A-share market, the bank noted, with plans in the works this year to set up a trial pension system, similar to 401(k)s in the U.S.

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Of course, HSBC is fairly bullish on China's market even as many investors are growing increasingly wary as the country faces a spate of bond defaults and concerns over its shadow banking system.

But HSBC blames the debt issues on an over-reliance on bank lending to allocate capital, which has spurred overcapacity in many of the industries now facing debt defaults.

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"The shift away from bank loans should allow the stock markets to expand their reach by financing riskier, more productive and innovative projects," such as the technology sector, HSBC said.

To be sure, not everyone expects the foreign-funds tap will be turned on anytime soon.

MSCI's plan to begin including A-shares in its indexes will start at a relatively low level "inclusion factor," of around 5 percent, compared with 20 percent for South Korea and 50 percent for Taiwan in the 1990s, Goldman Sachs said in a note.

The inclusion factor reflects the percentage of shares available for foreign ownership as well as excluding shares with low free floats.

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The change may lead to only about 27 billion yuan allocated to A-shares initially, or only 0.1 percent of the current market capitalization, it said.

Full inclusion in the index could be a long process, Goldman said, citing the 7-10 years it took for South Korea and Taiwan to reach those levels.

"The road for China to reach full inclusion could be even longer," subject to developments in its foreign-investment quota system and regulations for opening the capital account, it said.

—By CNBC.Com's Leslie Shaffer; Follow her on Twitter @LeslieShaffer1