What to expect from the Shanghai-Hong Kong Stock Connect?

Written by Jan Jetter || 07 Oct 2014

The Shanghai-Hong Kong Stock Connect Program is launching in mid October and significant changes to the Chinese capital markets landscape are to be expected. Also labeled as the (new?) “Through Train”, this program will give foreign retail investors access to 568 Shanghai-listed stocks, with a market capitalization of roughly USD 2 trillion, and many are already waiting in anticipation for the door to be opened. A brief analysis of the Shanghai Hong-Kong Stock Connect.

Will it be a success?

Ever since the April announcement, international investors have been familiarizing themselves with the Connect Program and have shown an eagerness to participate. With P/E ratios averaging 9.6, Shanghai A-shares offer relative discounts to Hong Kong H-shares equities and are among the lowest valuations in Asia. Foreign hedge funds are looking forward to take advantage of the possible arbitrage opportunities. The Shanghai stock market is down 60% since 2007, trailing GDP growth, and could offer investors significant upside in the long term.

Initial ramp up may be slow, due to daily quotas of RMB 13.5 billion and barriers that foreign investors must still overcome. Institutional investors are searching for local talent to deal with Chinese market and cultural idiosyncrasies and developing IT systems to ensure that trades are executed smoothly within the intricate mechanism of the stock program. Naturally, this takes time to implement and will be improved over time. However, investors can be expected to be in it for the long run. President Xi’s anti-corruption campaigns are starting to allay investors’ concerns about bad practices in boardrooms and with continued capital markets reforms the Stock Connect program may extend to the Shenzhen stock market and commodities market.

Allowing international investors to play a larger role in determining market prices was a key element in the new governments’ reform agenda and this sentiment has been reaffirmed through this pilot programme. Investors can also expect Chinese stocks to be listed on benchmark indices such as MSCI and FTSE, which will give them greater credibility and international comparability measures. MSCI will consider including Chinese stocks in 2015, which they previously have rejected due limited access to Chinese equities determined by the QFII program.

A turn for the good?

The Shanghai stock market in its currently iteration is relatively young, having only been re-opened in 1990. Its young age may explain some of the immature behaviour surrounding stock market investing and in allowing foreign capital the government is hoping to instil responsible and rational investment practices among local investors.

Ever since the 2006/2007 stock bubble, middle-class investors have perceived the stock exchange to be a “wild west” asset class and have opted for more risk-averse investments in real estate and savings accounts, both being methods of investment that have really never seen a downturn. Through the Connect program the Chinese government is hoping to restore confidence and stamp out irrational investors that have previously permeated the capital markets environment.

Investors wanting to catch a ride on the “Through Train” might have second thoughts considering that insider trading and bad practices in boardrooms are still in vogue. In addition to anti-corruption campaigns, President Xi’s government is hoping to put pressure to corrupt executives and put an end to unethical corporate governance practices with foreign capital now shaping the Chinese capital markets scene. If the goal is to improve the performance and stability of the Shanghai stock market, boardrooms must show good manners.

Chinese brokers and securities companies can also expect to ride the wave of incoming foreign capital. In helping to manage the quotas and offer additional services to funds unfamiliar with the market, incoming investment will be an opportunity to boost bottom lines of large brokerage firms such as Citic Securities and Haitong. Although foreign investors entering a new market have typically allocated only 5%-10% of commissions to local brokers, there may be opportunities for Chinese brokers to reap higher benefits if they are able to provide an added value to new funds unfamiliar with the local market.

The Stock Connect program will ultimately strengthen the financial relationship between Shanghai and Hong Kong stock exchange. It will help to promote the internationalization of the RMB; something that has been at the top the CCP’s agenda. By allowing Mainland investors to easily buy stocks in Hong Kong, it will help expand Hong Kong as an offshore RMB financial center and increase global RMB flows.

The Through Train is ready to start rolling.

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