The fact that China wants in on the modern world is not new. But just how comfortable Western investors should be might be news. Against the backdrop of the renminbi (RMB) internationalization process – the effort to make China’s currency ready for international markets – China has been pushing in recent years for capital market reforms and liberalizations. These steps have included multiple cross-border investment schemes such as Qualified Foreign Institutional Investors (QFII) and Renminbi Qualified Foreign Institutional Investors (RQFII), the Shanghai Free Trade Zone and the recent Shanghai-Hong Kong Stock Connect program.
The Shanghai-Hong Kong stock exchange link-up (also known as the “through train”) is one of the biggest developments in years for investors in international markets. Starting last November, foreign investors are now able to purchase individual shares (A-shares) of Chinese mainland stocks. The trading link adds 568 companies to investors’ universe of available stocks worldwide, which will open up an additional $2 trillion of investment options through preset quota programs. What’s unique about this scheme is that it marks a very significant breakthrough in the opening of China’s equities market. The program requires limited changes to existing legal and regulatory systems and market structures on each side of the markets, but it allows investors to trade across the markets with minimal incremental costs.
Trading under the Shanghai-Hong Kong trading link is subject to an aggregate cross-boundary investment quota as well as a daily quota. The northbound trading (i.e., the trading of A-shares by Hong Kong and overseas investors) is subject to an aggregate quota of RMB300 billion (roughly $50 billion) and a daily quota of RMB 13 billion, while the southbound trading (i.e., the trading of Hong Kong shares by mainland investors) is subject to an aggregate quota of RMB250 billion and a daily quota of RMB10.5 billion. According to data based on HKEX trading statistics, the market witnessed a somewhat disappointing welcome from overseas investors in the first month after the link launched, as average daily trading value of northbound trade stood at a little above RMB2 billion, which is only 16 percent of daily quota.
Nevertheless, both daily trade value and usage of quota have been gradually catching up over the past seven months, with average daily trade value climbing all the way up to RMB8.3 billion (65 percent of daily quota) in May and cumulative quota usage reaching more than RMB120 billion. Given the fact that actual quota usage is calculated as a netting (instead of aggregation) of total buy and sell trade values, total quota usage possesses less significance than daily trade value in reflecting market participants’ reception toward the trading link.
Currently, 66 companies are listed on both the Shanghai and Hong Kong exchanges. The Hang Seng China AH Premium Index tracks the average price difference of A-shares over H-shares for the largest and most liquid Chinese companies that are dual-listed on both exchanges. For most of the last five years, the H-shares have been trading at a price discount compared to their A-share counterparts. That said, the Shanghai-Hong Kong trading link will provide overseas investors – institutional asset managers, broker-dealers, hedge funds and retail investors – the arbitrage opportunity to buy A-shares that are discounted to their dual-listed H-share counterparts or vice versa. This is due to significant price differences between A-shares and H-shares across sectors.
With the actual time frame pending approval by the China Securities Regulatory Commission, China is set to launch a trial trading link between HKEX and the Shenzhen Stock Exchange; the latter is home to companies in the technology, pharmaceutical and clean-energy sectors.
While exposure to China has long been an important part of emerging-markets strategies, portfolio allocations to China have primarily been made by investing in Chinese companies listed in global centers outside China, such as Hong Kong, New York, London or Singapore. As MSCI held off from adding China’s mainland stock to its Emerging Markets Index and opted to work with China’s regulators to overcome remaining obstacles such as investor quotas and ease of access, regulators from China and Hong Kong are working together on the gradual removal of daily quotas from the trading links.
As such, the Shanghai-Hong Kong trading link and the upcoming Hong Kong-Shenzhen trading link are poised to provide a gate-opening opportunity to the global investment and trading community to monetize China’s growth story.
Gabriel Wang is a research associate with the Aite Group analysis firm.
