CEIC News@lert: Shanghai-Hong Kong Stock Connect Opens

November 17, 2014 BACKGROUND The linking of the stock exchanges of two important Asian financial centres, Shanghai and Hong Kong, is expected to take place on 17 November 2014. The link will allow Shanghai to more easily access the international market, while likewise allowing investors from Hong Kong and the global market to invest in the Renminbi-denominated China A-shares market via the Hong Kong Exchange’s (HKEx) platform. RELATIVE INDEX PERFORMANCE Based solely on returns, the benchmark Shanghai Stock Exchange Index (SSE) and Hong Kong’s Hang Seng Index (HSI) have seen volatile returns over the years. However, on a 10-year compound annual growth basis (CAGR), the HSI has often outperformed that of the SSE since late 2010. The HSI’s first quartile performance outperforms that of the SSE third quartile 10-year CAGR returns, although since 2014 these rates have started to converge to approximately 6%. THE HANG SENG CHINA AH PREMIUM INDEX A number of large Chinese companies are dual-listed on both the Hong Kong and Shanghai stock exchanges, and are known as H-shares and A-shares on the respective exchanges. Yet the price of Shanghai-listed A-shares is different from the same company’s Hong Kong listed H-shares most of the time. The Hang Seng China AH Premium Index is a useful indicator for the overall price differential between the A-shares and the H-shares. The index is defined as the valuation of constituents based on A-share prices over the same valuation based on H-share prices in USD terms. The index will be at 100 when A-share prices are at par with H-share prices on average. An index above 100 on a particular day means that A-shares, on average, are trading at a premium to H-shares. Conversely, when the AH Premium Index is lower than 100, A-shares are trading at a discount to H-shares. In theory, shares of the same companies that are traded in different markets in the world should be priced the same and arbitrage opportunities should not exist since the company valuation of the underlying shares, irrespective of where they are traded, should be the same. However, due to the tighter regulatory control and liquidity in China’s financial market than the rest of the world, companies that are dual-listed often have their shares priced differently on China’s mainland stock exchanges compared to those on the Hong Kong’s stock exchange. Over the past twelve months, A-shares were, on average, trading at a discount to their H-share peers. However, there have not been any obvious trends in the prices of A- and H-shares over the past three years. The difference did not seem to narrow immediately after the announcement of the linkage of the bourses in April 2014, when the AH Premium Index closed at 96.61 during the month. However, some convergence had taken place by October 2014, with the AH Premium Index closing at 98.52. In general, the price movements of H-shares are more exposed to the global financial market conditions, compared to A-shares. International institutional investors often invest in Hong Kong-listed shares after performing substantial research and thorough valuation on these companies prior to their portfolio selections. This results in a more liquid stock exchange. On the other hand, the turnover in mainland China’s stock markets is largely generated from individual investors, many of whom tend to have less time and resources to perform extensive stock valuation, resulting in more volatile share prices. Theoretically, the convergence of share prices of companies that are listed on two exchanges will take place when arbitrageurs buy the undervalued share in one exchange and sell the overpriced share of the same corporation in the other exchange. But A-shares and H-shares are not seamlessly convertible in this regard. An investor cannot buy a quantity of A-shares from the Shanghai Stock Exchange and sell the same quantity of shares immediately on the HKEx as H-shares, even if both represent stakes in the same company. The A-share market also has a much lower liquidity compared to the HKEx in terms of turnover. In addition, taxes on capital gains in mainland China can deter Chinese investors from benefiting from such price differentials. Besides the aforementioned market barriers, both northbound trading (HK investors acquiring Shanghai-listed A shares) and southbound trading (mainland Chinese investors acquiring HK shares) are subject to regulatory quotas. The daily quotas (i.e.: the maximum value of shares that can be ordered at any one point during the trading day) are RMB 13 billion for northbound trading and RMB 10.5 billion for southbound trading. The aggregate northbound and southbound quotas (i.e.: the maximum value of shares that can be traded in a day) are RMB 300 billion and RMB 250 billion respectively. However, both quotas are on a “net buy” basis, so investors will always be allowed to sell their cross-boundary securities regardless of the quota balance as long as there is a matching counterparty. Such quotas are expected to continue in the near future as to the authorities adopt a gradual liberalisation of the China’s stock market. Hence, the price gap between A- and H-shares may not vanish for some time even after the linkage of the two exchanges. INCLUSION IN MSCI It is also interesting to observe whether A-shares will eventually be included in the MSCI China Index and MSCI Emerging Markets Indices. The gradual inclusion of A-shares into such mainstream indices could make the A-shares market more appealing to fund managers who are looking for a balanced global portfolio and therefore considerably expand A shares’ access to the international capital market. Until the end of 2013, shares of Chinese companies listed on fully-liquid stock exchanges, proxy by the MSCI China Index, outperformed those listed as A-shares, proxy by MSCI China A Index, in terms of their average annual return rate over a ten-year investment period. Since then, the rate of return on the two indices has begun to converge. It is possible that the two indices will merge in the future if A-shares are freely floated and globally accessible to investors. On the other hand, if the two indices continue to exist respectively, the 10-year rolling CAGR of the two indices will slowly converge. While MSCI has decided in the 2014 Annual Market Classification Review in June 2014 that China A-shares will not be included in the mainstream indices due to investability constraints from the (RMB) Qualified Foreign Institutional Investor (RQFII/QFII) quota systems, the population of qualified investors is expected to continue increasing as China’s A-share market continues to liberalise. Combined with the Shanghai – Hong Kong Stock Connect program, the potential for future inclusion of A-shares into the mainstream MSCI indices remains high. IMPLICATIONS OF THE SH-HK CONNECT The Shanghai-Hong Kong stock market linkage will be an important step for China to liberalise its financial market, with turnover of both stock exchanges expected to increase along with the number of market participants in both markets. The People's Bank of China (PBoC) mentioned its target is to entirely open up China’s capital market to the world by 2020 with the gradual withdrawal from routine monetary intervention. The amount of offshore Renminbi in Hong Kong has increased significantly by 16.2 times, from RMB 58.2 billion as at the end of September 2009 to RMB 944.5 billion at the end of September 2014. The pool of offshore Renminbi is expected to continue to rise as part of the effort by the Chinese government to increase the currency’s liquidity in the international capital market. Challenges remain as the authorities work towards the mammoth 2020 goal. Baby steps are being taken with the recent announcement to scrap the daily cap on RMB conversion by Hong Kong permanent residents to line up with the launch of the Shanghai – Hong Kong Connect . There are many outstanding issues yet to be clarified, such as China’s financial market regulations regarding taxes due on capital gains by foreign and HK investors, and the maximum limit of 30% of a China-listed firm that can be owned by overseas investors in total. Moreover, the ongoing protests in Hong Kong have added some uncertainties to the confidence of Chinese official in using Hong Kong as a platform to liberalise the Chinese capital market. Discuss this post and many other topics in our LinkedIn Group (you must be a LinkedIn member to participate). Request a Free Trial Subscription. Back to Blog
17th November 2014 CEIC News@lert: Shanghai-Hong Kong Stock Connect Opens