Risks And Opportunities In Shanghai Hong Kong Connect

Risks And Opportunities In Shanghai Hong Kong Connect

November 18, 2014 0 Comments

Summary

Shanghai Hong Kong Connect is a huge event for investors and for the global economy.
Foreign investors and mainland China investors are now able to own each other’s stock for the first time.
Part of the Chinese government strategy to develop Shanghai as a global financial center, globalize the RMB and attract foreign capital.

There is a major financial storm system in Hong Kong and Shanghai. Beginning today, foreign investors and China mainland investors are able to own each other’s stocks for the first time. It is a perfect illustration of Safanad’s investment approach. Two separate systems — Hong Kong and Shanghai stock markets — with different prices and returns are being combined into one system by opening the markets to cross-border investment. The result will be unsustainable return differentials that will lead to major price movements in both markets.

I did an interview on CNBC Power Lunch on the topic. You can see the interview by clicking here.

CNBC Power Lunch. Hong Kong Shanghai ConnectThe opening of two-way stock market traffic is a huge event for China, far more important than anything that took place at last week’s APEC meeting. This opening of two-way capital flows will create important opportunities for careful investors on both sides of the ball. The 3 key questions:

What is Shanghai Hong Kong Connect?
What does it mean for investors?
What does it mean for China and the world?

What is Shanghai Hong Kong Connect?

A “pilot program” that allows Chinese and foreign investors to invest in each other’s shares for the first time.
Northbound investment. Hong Kong and foreign investors will be allowed to invest in 268 designated stocks (Gang gutong shares) out of the 971 A-shares listed on the Shanghai stock exchange (SSE).
Both lists are expected to be increased over time after the pilot program stage. Investments in both directions are subject to quota limits of 13 billion RMB, about $2 billion per day.

What does it mean for investors?

For Hong Kong and foreign investors this is the first opportunity to invest directly in the stocks of most of the major mainland Chinese companies, rather than being limited to ADRs and the relatively few companies listed outside China.

For mainland Chinese investors, this is the first opportunity to invest in most of the companies listed in Hong Kong. It is also their first “legal” opportunity to move the wealth they have accumulated in China to other, politically safer, jurisdictions. (This is very important, given Chinese history).

The program will likely be opened to “foreign RMB investors,” i.e., foreign investors with RMB balances who want to invest directly in China, after the pilot program. The reason this is important for investors is that there have been very large price differences for the same stocks listed in both the SSE and HKSE (see table below).

Dual Lsited Share Prices SSE HKSE

This table, included in the investor briefing materials published by the SSE, shows that for the top 10 stocks listed in both markets, Hong Kong prices averaged 12.9% higher than Shanghai prices during the first 6 months of 2014 for shares in the same companies. For all 69 shares listed in both markets, however, Hong Kong shares sold at a 10.05% discount below their Shanghai levels, implying that smaller Chinese companies trade at substantially lower prices in Hong Kong than they do in Shanghai.

What do these prices mean? Foreign institutional investors, unable to buy Chinese stocks directly, drove the prices of dual-listed, large-cap Chinese companies up relative to mid-cap companies in the Hong Kong market compared with their SSE prices. When trading opens, we would expect prices to be driven closer together in both markets.

The biggest gains? Mid-caps in the Hong Kong market and large-caps in the Shanghai market, especially banks, insurance, energy, and telecom shares. To some degree, investors have been doing this already. Shanghai prices increased +1.38% the day the program was announced last April, and +17.8% since then. Hong Kong prices +5.5% since April.

Be careful, though. The behavioral finance literature has concluded that stocks listed in 2 markets can have quite different prices for long periods, even between markets as efficient New York and London and companies as well understood as Royal Dutch Shell (NYSE:RDS.A) (NYSE:RDS.B).

The biggest risks? Large-cap China stocks listed in either Hong Kong or US markets. China-focused mutual finds and ETFs. Institutional investors, unable to purchase mainland China stocks directly, drove up the prices on close substitutes like large Chinese companies listed in Hong Kong (H shares) and ADRs listed here. Mutual funds and ETFs were forced to build portfolios containing these over-priced shares. (Both the iShares China Large-Cap ETF (NYSEARCA:FXI) and SPDR S&P China ETF (NYSEARCA:GXC) fell sharply today.) Be careful to look what is in the portfolio before buying in the coming weeks. As a side note, there will be an ETF for the Shanghai market available soon, although daily quotas will make it difficult to track the index with any precision.

What does it mean for China and the world?

This is very important for the Chinese government. Selected language from government announcements include:

  • “new era”
  • “historic moment for China’s capital market”
  • “breakthrough for China’s capital market”
  • “facilitate the opening up of China”
  • “the first train for A shares to go global”
  • “a road to the overseas stock market in a short time”
  • “closely related to China’s economic development”
  • “market-oriented reform for interest rate and exchange rate”
  • “gradual convertibility of RMB”
  • “serving RMB internationalization”

Shanghai Hong Kong Connect serves China’s plan to build a global market for the RMB. Chinese leaders concluded in 2008 that the US and EU were both unstable anchors for their monetary system. As a result, they are attempting to build their own Asia-centric currency bloc. Chinese leaders believe that opening the market will bring more capital into China, which means higher and more stable growth. Therefore, Hong Kong Shanghai Connect is part of a larger long-term strategy of the Chinese government to open the economy and globalize the RMB.

Hong Kong’s pivotal role in developing Shanghai and the Chinese financial system is also one of the major reasons Chinese authorities are unwilling to make compromises in dealing with Hong Kong demonstrators. It is no accident that the first pilot program is being launched in Shanghai. Xi Jinping and Li Keqiang are part of the Zhang Zemin-led political faction known as the Shanghai Gang.

Wild card? This is the first time we have been able to get a good measure on the desire of mainland Chinese investors to move their wealth out of China, which will be the key to movements in the RMB/$ exchange rate. On the first day of trading, Northbound orders were ten times as large as Southbound orders. So, it appears that investors expect foreign investor interest in China to exceed Chinese interest in going abroad. It will be interesting to see if this pattern continues over time.

 

John Rutledge

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