Connecting the Dots

Chan, Kalok（陳家樂）,

With the launch of the Shanghai-Hong Kong Stock Connect, investors both inside and outside of mainland China are anxious to know what the future holds for the financial markets in Hong Kong and China

By Louisa Wah Hansen

Amid much anticipation and a short period of anxiety, the Shanghai-Hong Kong Stock Connect was launched on November 17 to formally link the two cities’ financial markets through an unprecedented exchange mechanism. The link aims to lift the previous barrier in capital flow so that more investors can participate in stock market activities on both sides of the border. It is also hoped that in the long run, capital resources can be allocated more efficiently through a new price discovery process, and that both Mainland China and Hong Kong will benefit from an expanded financial market.

A Watershed

Prof. Kalok Chan, Dean of CUHK Business School and Wei Lun Professor of Finance, says the Connect is definitely an improvement over the old system, as it is now easier for retail investors in Hong Kong to participate in the China “A” share market. Institutional investors used to dominate the trade before the new mechanism was put into place. At the same time, he says, the Connect allows capital from Mainland China — including that from retail investors — to come out of the domestic market much more easily. “Despite the fact that there is still capital control imposed by the Mainland authority, this is a big step in liberalizing the capital restrictions. So I think it has a significant implication going forward,” he comments.

According to Simon Lee, Senior Lecturer of the School of Accountancy and Co-Director of the Integrated BBA Program at CUHK Business School, the Connect marks the beginning of a significant transition in the nature of RMB usage in Hong Kong. “Prior to the establishment of the Connect, the role of RMB in Hong Kong was mainly that of savings and loans. But now, it allows Hong Kong investors to trade stocks on the Shanghai board using offshore RMB in Hong Kong,” he says.

From a broader perspective, the Connect plays a much larger role in China’s quest to bring its currency to the world stage. Lee describes the creation of the Connect as the second phase in RMB internationalization, the first phase being the use of RMB in cross-border trade. In the second phase, RMB is widely used in foreign direct investments. In the third phase, RMB will play the important role as the country’s reserve currency. Lee cautions though that without sufficient number of bonds carrying different years of maturity, it would be a long way before RMB reaches this phase.

Initial Hiccups

While a freer flow of capital in and out of both markets is one of the biggest attractions of the new mechanism, the Connect is not without its share of issues, especially in the early days of trading. Prof. Chan points out that the Shanghai and Hong Kong exchanges are not completely synchronized in terms of trading hours, settlement methods and treatment of taxation. “Some discrepancies between the two markets may make it inconvenient for investors, so that the Connect may not realize its full potential as yet,” he says, citing the examples of different public holidays and company disclosure policies.

“The standard and degree of transparency is different,” he continues. “Hong Kong is a more international market and Shanghai is still developing, so for investors in either place to trade in the other market, it requires a certain degree of adjustment. They need to realize that this is not the same game as what they had been playing.”

According to Lee, corporate governance issues of the listed companies in Shanghai can be a deterring factor in attracting investors from Hong Kong. Lee suggests these investors to spend more time and effort in performing due diligence when investing in the Shanghai market than they would when investing in the Hong Kong market. “They may find that some crucial investor information is not readily available and therefore need to spend more time digging it out.”

It is a tricky issue when it comes to information transparency. Prof. Chan believes that the more interest there is in the “A” share stocks, the more analysts from international banks and journalists will be covering them, thereby helping investors to make informed decisions. “This kind of information will help investors detect occasions when companies are engaged in improper behavior,” he says. “But of course, it’s a chicken-and-egg problem. You’ve got to have the interest from investors first before more information would be generated. But to get that interest you need to have a certain amount of transparency first.”

Traffic Imbalance

Despite the fundamental obstacles, Hong Kong-based investors had demonstrated huge enthusiasm over “A” shares during the first few weeks of trading, often using up the northbound daily quota for trading volume, capped at RMB13 billion. On the other hand, southbound traffic had been lackluster.

Prof. Chan explains that this is due to the fact that retail investors dominate the mainland stock market whereas the Hong Kong market is dominated by institutional investors. Mainland retail investors generally have a very short-term trading mentality and therefore tend to invest in stocks that are easy and convenient to trade rather than going through the Connect, which presents some obstacles as discussed above. Besides, he adds, there are probably enough stocks on the Shanghai board for them to choose from, so the Hong Kong market would not necessarily be a great attraction. “The exception would be if the same company is listed on both markets, and if the prices are much cheaper in Hong Kong, then mainland investors would be more willing to participate,” he says.

The key to a greater southbound traffic is if the number of mainland institutional investors increases significantly. However, this depends on whether regulatory changes will happen. The Chinese Government has prohibited mutual funds, retirement funds, insurance and the like from including equity due to the perceived high level of risk. But Prof. Chan says the Government has yet to realize that a certain proportion of equity in the portfolio is healthy in the long run.

Future Outlook

Would the two exchanges start to move toward each other in their trading characteristics in the future, so that the Shanghai market would become more value-driven and the Hong Kong market would become more volatile?

“Probably not at the current size,” contends Prof. Chan. “Further down the road, there may be some cross-exchange influences, but not until the daily quota is relaxed.”

How about the valuation of stocks? Would stock prices in the two markets move closer to their counterparts?

Lee observes that before the recent boom of the “A” share market, Hong Kong shares used to be a bargain compared with “A” shares. However, the situation has reversed. “This reflects the fact that it takes time for the shares in both markets to reach their fair values. Currently, they are in the process of doing that. The Shanghai ‘A’ share market is still not fully open yet, and it’ll take some time before the Shanghai-Hong Kong Stock Connect will reach a high utilization rate. When that happens, the stock prices in both markets will reach fair valuation.”

Prof. Chan adds: “If the ‘A’ shares continue to go up and become more and more expensive, maybe mainland investors would want to trade more in Hong Kong for bargain prices. But this is pure speculation.”

Another question that investors have in mind is: Besides a linked financial market between Shanghai and Hong Kong, will links between Hong Kong and other mainland cities such as Shenzhen be in the horizon?

It is possible to have such a link between Hong Kong and Shenzhen, says Lee, “but not too soon. We have to wait and see how the Shanghai-Hong Kong Stock Exchange turns out before the concept is extended to other markets. The Shanghai market is by far the biggest one in Mainland China. If the problems associated with the Connect aren’t handled smoothly, adding Shenzhen to the mix may not be such an attraction for investors.”