Shanghai-Hong Kong Stock Connect: A Reflection on the Early Trading Days

By Alex Shiu, Executive Director of China Frontier Capital Investment Ltd., Hong Kong.He graduated from the Chinese University of Hong Kong with an Integrated International Business degree in 1990 and obtained his postgraduate degree, the Diplôme Grande Ecole, from Hautes Etudes Commerciales in Paris in 1992.

Volatility is not as simple as it seems. Technically speaking, when we talk about risk, it’s about things happening not quite as we expected. And it’s not only about when something gets too hot, it’s also about when it gets… well, a bit too cold.

The case of Shanghai-Hong Kong Connect is a good demonstration on how things may not go quite as expected, despite a sound logic and motivation behind it. It would be terrific if the world works according to logic alone, but here we are in a real world where common sense works better than logic.

The Shanghai-Hong Kong Connect received a lot of enthusiastic support when first announced. In fact, the positive comments were so overwhelming, that a lot of common-sense requests for clarification became small talks on the side line—until when things didn’t quite happen according to the script, and small talks turned into prophecy. To be fair, comments that are too positive or comments that are too negative are not very helpful in arriving at an informed opinion. What we need is a common-sense point of view: Get the facts right before we make any judgments.

The fact is, China is still a premature capital market, and things are bound to be bumpy as it moves forward trying to find its own path of development.

Even from those who are strong supporters of the new exchange mechanism, the fact has always been starring at our nose[1].

The China stock market is 82% dominated by retail investors, who exhibit an addictive taste on “new” sectors such as software and media, rather than traditionally “safe” sectors such as energy and insurance. So, a higher degree of volatility is inevitable. This can be explained by a simple comparison with the Hong Kong stock market, where institutional investors constitute the mainstream rather than retail investors[2], who make up only around 17 percent of the total amount of cash trading value. Almost the exact opposite can be seen in the Mainland China stock market.

When it comes to predicting how investors on both sides would react when the markets are sort of “open,” though, there is another surprise which should not be a surprise at all. During the first day of trading after the Connect was launched on November 17, the northbound quota were fully used before noon, while only about 17 percent of the quota for southbound orders were utilized.

Theoretically, if a market is dominated by retail investors, the crowd should be more “emotional” when there is a chance to speculate in a new market, such as Hong Kong, which was legally off-limit to PRC local retail investors, whereas for seasoned institutional investors, action would be a bit reserved in the opposite direction.

Statistics, however, showed the contrary to be true[3].

The reasoning for the lackluster southbound demand was that “it takes time for mainland retail investors to get to know the Hong Kong equities market.” Well… not quite. The fact is, PRC investors might have become too familiar with the Hong Kong market already. Things have always been in the gray zone when it comes to Chinese money, but at least the Bank of China is not shy about admitting the many ways Chinese nationals can “legally” get their money out of China to make investments.[4]

In fact, the familiarization process began back in 2003 when the Individual Visit Scheme was launched[5]. Hong Kong’s Securities and Futures Commission already made the observation back then, that the following series of events could not be isolated from the impacts felt on the stock market: the launch of the Individual Visit Scheme; the relaxation of the cap on foreign currency that mainland residents were allowed to bring into Hong Kong; the signing of the Closer Economic Partnership Arrangement (CEPA) agreement and the possible inflow of capital into the stock market as a result; the improved sentiment of major markets and other speculations such as the introduction of QDII later.

If all these activities have been going on for more than a decade, what is new to attract a surge in investor appetite from the Mainland? Again, this is just real common sense.

The early northbound rush also proved short-lived and quickly receded. “Tax exemption” is probably the real motivator for QFII investors to “switch” to investing directly in “A” shares through the Shanghai-Hong Kong Stock Connect. Under the old system, foreign investors were allowed to invest in “A” shares through their QFII quota, but the stocks were costly to begin with and then there was the “capital appreciation tax” to make provisions on[6]. The sudden announcement of “tax exemptions” on the Connect was thus honey to a bee. But once the switch was made, how are we going to convince investors to make more allocations on the mainland counter without seeing any change in the market fundamentals? The jury is still out on this one.

When I was still studying at the Chinese University of Hong Kong almost 30 years ago, I often made the following comment about the China’s capital market: “It lacks a reliable intermediary.” Despite the full support by the Central Government to open its market, and despite China’s strong attempts to secure its own position in the world capital market, I still have to say the same. When it comes to the capital market, it’s not just about size. Professionalism is more important, and the details behind how things work cannot be overlooked.

Here I would better leave the statement open to legal experts who still have lots to say on the issues yet to be resolved. Global law firm Linklaters issued a report as late as October 2014 to try to raise some red flags. Among the lingering issues are: beneficial ownership protection, non-trade transfers, margin financing and stock borrowing, to name just a few.[7]

Without truly resolving these issues and aligning its market with the global standard, China, in my view, still has a long way to go before it finds a rightful place under the sun—as far as capital market is concerned.

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References:

[1] Hong Kong Exchanges and Clearing Ltd. report, Feb 2014 http://www.hkex.com.hk/eng/stat/research/Documents/cmts2013.pdf

[2] Goldman Sachs report, Sept 2014 http://www.goldmansachs.com/our-thinking/trends-in-our-business/stock-connect/report.pdf

[3] http://www.thestandard.com.hk/news_detail.asp?pp_cat=30&art_id=151505&sid=43385075&con_type=1

[4] http://investinginchinesestocks.blogspot.hk/2014/07/4-ways-of-getting-money-out-of-china.html

[5] SFC Report http://www.sfc.hk/web/doc/EN/speeches/public/bulletin/sfc_bulletin/autumn03_mktup.pdf

[6] PWC Research http://www.pwccn.com/webmedia/doc/634675174056809613_rcs_qfii_cgt_mar2012.pdf

[7] Linklaters Report Oct 2014 http://bit.ly/1yCf6tJ

Disclaimer:

The opinions expressed here represent those of the author and not those of CUHK Business School or any employee thereof.