By Nicholas Ronalds, Managing Director-Equities, ASIFMA with Tamir Abdelwahab, Analyst-Equities, ASIFMA
(Although the Stock Connect scheme also accommodates Southbound flows enabling Mainland China investors to buy and sell Hong Kong-listed stocks, this article focuses on Northbound flows only, which are more relevant to non-Mainland investors.)
Sophisticated international investors have been able to use other channels to buy into the China story, in particular through the Qualified Foreign Institutional Investor (QFII) and Renminbi Qualified Institutional Investor (RQFII) programmes, since the early ‘oughts. However, these QFII programmes are restricted to blue-chip institutional investors and have been hemmed in by rules on how much can be invested in which asset class, and more irksome, by restrictions on the timing and amount of repatriation is allowed.
Stock Connect avoids these disadvantages. It allows any investor to buy eligible China A shares, and to sell them any time—subject to the caveat that day-trading is prohibited on Chinese exchanges.
What are the eligible Shenzhen shares? Stocks in the SZSE Component Index and SZSE Small/Mid-Cap Innovation Index with a capitalisation of at least RMB 6 billion ($885 Million) will be eligible. The SZSE Component Index is made up of the Shenzhen exchange’s 500 largest stocks; the SZSE Small/ Mid-Cap Index is composed of small and mid-cap issues including those in the ChiNext Board, which features stocks of China’s most speculative—but presumably also some of the most dynamic and promising—young companies.
There is one restriction on access to these Shenzhen stocks: only institutional “professional” investors will be allowed to buy names on the ChiNext board, at least initially, to safeguard retail investors from exposure to volatile and risky issues. The capitalisation of the 880 stocks in Shenzhen Connect adds up to RMB 15 trillion, nearly threequarters of the exchange’s total capitalization. For comparison, the 567 shares in Shanghai Connect represent a market cap of RMB 21.8 trillion and 85% of the Shanghai Stock Exchange’s (SSE) total market cap. When it comes to trading volume, Shenzhen punches well above its weight, typically trading more in terms of either share volume or share value than the SSE.
Dynamic Young China
The SZSE lists more companies from China’s young, dynamic companies in IT, health care, science and manufacturing. For example, Shanghai lists 30 IT and software companies compared with 150 in Shenzhen. Shanghai has seven companies in scientific and R&D fields, Shenzhen 15. Most of China’s publicly traded media companies are listed in Shenzhen, which also has more than twice as many manufacturing companies—1,272 versus Shanghai’s 599.
It’s usually the case that exciting growth companies carry high price tags, and valuations in Shenzhen are no exception. The average price-earnings ratio (PER) of A-shares in Shanghai is a reasonable-looking 15.6; Shenzhen’s is 43. This average conceals quite a range—the 546 Chinext stocks’ PER’s hover at a lofty 78. The flip-side of the valuation story is that fastgrowing companies often have zero earnings because cash flow is being ploughed into growth. Hence, a high PER doesn’t necessarily imply overvaluation. (For comparison, Amazon recently had a PER of 181.) Stock pickers will have good reason to scrutinize Shenzhen stocks and some skilled (and some lucky) investors will doubtless score enviable returns on their picks in the coming months and years.
The A-H Anomaly
In addition, Stock Connect includes all A-shares on the Shanghai and Shenzhen exchanges for which H-shares are trading on the Hong Kong Stock Exchange (HKEX). H-shares are shares of Chinese companies listed in Hong Kong. A subset of H-shares (about 38%) is dual-listed on both the HKEX and one of the Chinese exchanges: there are 70 dual listed Shanghai Exchange H shares and 17 dual listed Shenzhen H shares. A- and H-shares are economically identical in the sense that they represent the same ownership share, voting rights, and receive identical dividends per share.
When Shanghai Stock Connect launched in November 2014, many investors thought arbitragers would use stock connect and on-shore channels to keep A- and H-shares at parity. It turned out to be a badly losing bet. The A-H differential actually increased steadily after the launch and averages around 20% as of end-October, 2016. For example, Zhejiang Shibao, traded at HKD 11.58 in Hong Kong and RMB 43.71 in Shenzhen. Adjusting for the currency difference, the H-share was at an astonishing 77% discount to the A-share—an H share of the same company could be bought at less than a quarter the price. Similarly, Luoyang Glass, an H- share dual-listed in Shanghai and Hong Kong, traded at one-fifth the price of the A-share.
The A-H anomaly has not surprisingly attracted considerable interest from academics and traders. Index manager FTSE has even created an index that seeks to exploit the variation in the A-H differential over time in a modified China A50 index that swaps into the cheaper share, A or H, on pre-determined criteria.
Stock Connect is a link between exchanges inside and outside China such that orders for Chinese shares (Northbound) have to go through order routing and clearing links from HKEX to Shanghai or Shenzhen via a broker who is a member of the Hong Kong Stock Exchange. The more typical arrangement for customers in one country seeking to trade on an exchange in another country is via their broker’s relationship with a broker in the country of the target exchange, not via a link between the exchanges.
The reason for this “link” mechanism between exchanges rather than the more conventional model is that the Chinese authorities want to create access to China’s equity markets but in a way they can easily supervise and adjust if need be. RMB used to buy stocks through Connect, for example, must be returned in Hong Kong when a stock is sold and can’t be re-used for other purposes in China. Such a “closed loop” for the currency wouldn’t be possible using conventional arrangements.
The authorities also have to enforce a quota, which is easier via a link. When Stock Connect was first launched a quota put an upper ceiling of RMB 300 billion (USD 44 billion) on the total investment allowed through the scheme. That quota will be abolished with the launch of Shenzhen Connect, but a daily quota of RMB 13 billion remains.
If Chinese regulatory authorities want to investigate suspected abuse, they can do so through their familiar relationships with the Hong Kong Exchange and the Hong Kong regulators.
As of early November, one big question mark still looms: what will be the tax treatment of equities purchased via Shenzhen-Hong Kong Stock Connect? For Shanghai Stock Connect, the authorities waited until the last day before launch to announce that capital gains will not apply to stocks bought and sold via Stock Connect. The street is widely assuming the Chinese authorities will accord Shenzhen Connect the same treatment—nothing else makes sense. But without an official announcement the uncertainty lingers causing delays with internal systems and client documentation that either can’t be completed or must contain additional caveats to take the uncertainty into account.
The Futures of Connect
Stock Connect is still being called a pilot program. It will grow and evolve in the coming months and years. The HKEX has announced that it will add ETFs to the scheme’s product suite in the near future, probably in 2017. Next on the wish list are derivatives, such as stock index, currency, and ETF futures and options. Eventually primary market listings might also be included.
Looking farther out still, one question is, what happens when China’s capital account becomes truly open, with capital free to move in and out without restriction? A scheme like Stock Connect would arguably be redundant because foreign brokers could establish direct relationships with on-shore Chinese brokers, just as they do in equity markets around the world. At that point Stock Connect might fall into disuse.
On the other hand, Stock Connect could by then be working so well, and be so well established in investors’ and intermediaries’ systems that investors just might decide to stick with the model that works. If HKEX plays its cards well Stock Connect could remain the preferred channel for investing in China’s stock market, quirky, unique, but effective.
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