Monday, 17 November 2014

Hong Kong Shanghai Connect: A Huge Leap Forward

The Hong Kong-Shanghai Connect has finally started. 

This is a very, very significant step in the reform process that China has started, and as outlined in 2013 during the Third Plenum (please see our China Compass of both March and May 2014), this is an important puzzle piece in the whole financial reform and liberalization process: a PRC stock exchange has opened up to the world.

Non PRC investors (not only Hong Kong residents but all overseas investors) are now able to directly buy shares listed on the Shanghai stock exchange, (“northbound”), and qualified PRC investors (individual investors with a minimum of RMB 500k in their accounts, in other words the better off) are able to invest in HK listed stocks (“southbound”), (including of course the international firms that have used HK as a listing exchange, who will now benefit from a huge potential new investor base).

There are exceptions in both directions, such as shares not traded in RMB in Shanghai (so called “B” shares) or not traded in HKD in Hong Kong, or Hong Kong shares with a dual listing in another Chinese city than Shanghai. 

Also the Hong Kong Shanghai Connect does not work for IPO’s; international investors can continue to participate in HK IPO’s, but not in Shanghai as yet. Similarly the Chinese investors in Hong Kong IPO’s cannot use the Connect for this purpose. This is bound to change over time.

Nevertheless the two exchanges become so closely intertwined, that this is clearly the first step of a long process through which ultimately One China Exchange will be created. Already there is talk of a future addition of Shenzhen to this couple, creating a really powerful threesome.

Already the new “virtual” HK-Shanghai combination becomes the 2nd largest stock exchange globally by capitalisation, and 3rd largest by turnover.

Focusing first on the northbound traffic into Shanghai:

Suddenly 985 Chinese companies (855 that did not have a dual listing with HK), become accessible to the global investment community. This will increase the global investment focus on the top companies in this group, which will slowly but surely have a positive impact on transparency. The global investor focus on China will increase, and evolve from just macroeconomics to specific company analysis. (Knowledge of Putonghua and a real understanding of China will be a plus!)

There is also a deeper agenda; many SOE’s have listed subsidiaries in Shanghai. International investors will over time force the SOE’s to act increasingly like the private sector, which fits perfectly with the Governments agenda to stimulate SOE reform.  

Remember that the new mantra is that “market forces will play a decisive role in the allocation of all resources”, which includes capital, and includes SOE’s. Similarly the Government is looking for private investment in the public SOE’s, in order to assist them to reform. The Connect is a backdoor into some SOE’s.

With regard to the southbound traffic:

Chinese investors have had limited opportunities to (legally) invest their funds; hence the real estate prices, the success of Yu E Bao (Alibaba’s savings account), and the wealth management products linked to shadow banking.

We believe the demand for diversification is very strong, (driven also by a very high savings quotient) and therefore the chance to invest in Hong Kong stocks that are not also listed in China, or even sectors that are not available through the Chinese exchanges, will be taken up with huge eagerness.

Other issues that will logically materialise:

The purpose of Chinese companies having dual listings SH-HK mostly falls away. This is bound to have a longer term negative impact for Hong Kong, as Hong Kong was also the PRC company’s window to the west. The Shanghai listed PRC companies will over time likely opt to focus on Shanghai, and delist their HK shares, as currency exchange regulations also liberalise.

On the other hand however, Hong Kong does become more important as a listing exchange for international companies seeking exposure to Chinese investors.

All in all exciting times. The Connect is but another step forward on the reform path, albeit a huge leap for Chinese financial reform.

Daniel P. de Blocq van Schetlinga
Polarwide Ltd.