On the Horizon: Shenzhen-Hong Kong Stock Connect

The soon-to-be launched Shenzhen-Hong Kong Stock Connect has gained a lot of media attention recently. What is the meaning behind this new investment platform, how is it different from the Shanghai-Hong Kong Stock Connect and can it benefit Hong Kong?

By Liu Yang, PhD Candidate in the School of Accountancy, CUHK Business School

The Shenzhen-Hong KongStockConnect is a channel provided by the Shenzhen Stock Exchange and Hong Kong Stock Exchange that will allow Hong Kong investors to buy stocks listed on the Shenzhen Stock Exchange main board, part of the SME Board（中小企業板） and ChiNext（創業板）[1]. At the same time, it will allow Chinese domestic investors to directly buy stocks listed on the Hong Kong Stock Exchange. There is a daily ceiling for the trading volume on both sides of this channel. Once the total trading volume reaches the upper limit, the channel is closed automatically. Based on the experience of the Shanghai-Hong Kong Stock Connect, the trading volume would not reach the ceiling most of the time.

Thus far, there are three channels for capital flow between mainland China and Hong Kong: QFII, QDII, and the Shanghai-Hong Kong Stock Connect. Each of them is focused on a different aspect.

The first channel is QFII, which stands for “qualified foreign institutional investors.” In 2005, the Chinese Securities Regulatory Commission (CSRC) issued the first list of foreign institutional investors who could invest directly in mainland China’s capital market.

The second channel is QDII, which stands for “qualified domestic institutional investors.” In 2007, CSRC announced a list of domestic institutional investors who could invest directly in foreign capital markets, including Hong Kong. So, by June 2007, both domestic and foreign institutional investors could freely invest in and out of China.

The third channel is the Shanghai-Hong Kong Stock Connect, introduced last November, allows both mainland China and Hong Kong individual investors to buy stocks in Shanghai’s and Hong Kong’s stock markets. The RMB and Hong Kong dollar are exchanged automatically during the transactions. However, the stocks listed on the Shanghai-Hong Kong Stock Connect are focused on blue-chip companies, which are comparatively large and good-value companies. Since these blue-chip companies are undervalued in the A-share market, after the Shanghai-Hong Kong Stock Connect was launched, the undervalued stock prices dramatically went up. In other words, the Shanghai-Hong Kong Stock Connect mainly benefits the A-share market.

In the Hong Kong stock market, there are a lot of small stocks are not very actively traded (illiquid). Institutional investors do not favor those stocks, and the prices are undervalued compared with similar stocks in other capital markets. Therefore, it is worth exposing these stocks to more investors. The Shenzhen-Hong Kong Stock Connect is targeted at these small stocks in Hong Kong and will allow mainland individual investors to invest them directly. If the Connect is launched by the end of 2015, the small stocks will benefit a lot from this policy, which is expected to improve the resource allocations.

How would Hong Kong benefit? What are the potential consequences?

The stocks to be listed on the Shenzhen-Hong Kong Stock Connect will not be officially disclosed to the public until much later. However, the market has already selected some of the stocks in Hong Kong as potential players. Comparatively speaking, the price-earning ratios (PEs) of the smaller stocks in Hong Kong are lower than those in the Shenzhen market. This is because there is an overwhelming large percentage of retail investors in mainland China, who prefer smaller stocks and thus drive up their prices, whereas the proportion of retail investors are much lower in Hong Kong. In other words, the smaller stocks in Hong Kong market are undervalued compared with their Shenzhen counterparts and have a higher potential to increase in price. As such, the Hong Kong stock market stands to benefit more from this Connect.

As Hong Kong is a major RMB off-shore financial market, the more capital connections it has with mainland China, the larger the demand for such an RMB off-shore market. As such, the new Connect is expected to enhance Hong Kong’s status as international financial center. At the same time, however, it is also expected to bring pressure to Hong Kong’s linked exchange system, because the demand for the Hong Kong dollar will be substantially increased due to the increase in capital flow into the Hong Kong capital market. For this, the Hong Kong Monetary Authority has to inject a matched amount of money into the market. In turn, this may drive up inflation in the city.

What is the difference between Shanghai-Hong Kong Stock Connect and Shenzhen-Hong Kong Stock Connect?

Firstly, the Shanghai-Hong Kong Stock Connect targets large blue-chip companies whereas the Shenzhen-Hong Kong Stock Connect targets smaller companies with growth potential. Secondly, the investment threshold for the Shanghai-Hong Kong Stock Connect is 500,000 RMB for individual investors in mainland China whereas under the Shenzhen-Hong Kong Stock Connect, it is possible that the threshold will be lowered substantially. Therefore, the capital inflow from mainland China will likely increase after the Shenzhen-Hong Kong Stock Connect is launched. Thirdly, the daily quota of the Shanghai-Hong Kong Stock Connect has been used up several times. Even though such an occurrence is not so frequent, there is a chance that the daily quota for the Shenzhen-Hong Kong Stock Connect will be raised.

The large companies listed on the Shanghai-Hong Kong Stock Connect are rarely suspended. But with the Shenzhen-Hong Kong Stock Connect, the smaller companies are more likely to undergo mergers and acquisitions, during which the stocks will be suspended. In the A-share market the suspension period is usually longer than that in the Hong Kong market. During that period, money cannot be withdrawn from the stock market, and the frozen period may bring opportunity costs to investors. How to handle this problem is something still under discussion between the two sides

What are the market expectations?

As investors expect the smaller stocks with cheap prices in Hong Kong to increase in prices after the Shenzhen-Hong Kong Stock Connect launches, many individual investors in Hong Kong have already bought those stocks to wait for the new Connect to be started. One popular platform named “gelonghui” even provides a “HK-A 100 index,” which contains 100 stocks that have a higher probability to be listed on the new Connect, and tracks them to provide the latest information on these stocks.

According to the current market expectations, the Hong Kong market will become more prosperous after the launch of the new Connect, whereas the small, good, growing and cheap firms in Shenzhen will also be benefit. However, even though the Shenzhen market has a lot of small, good and growing companies, cheap ones are already quite hard to find nowadays.