Hold on for the gravy train?

It was dubbed “big miracle day”, recalls Apple Daily. On August 17, 2007, Hong Kong shares plunged more than 1,300 points on worries being stoked about the looming global credit crisis. Then China’s currency regulator made what was arguably the most market-moving announcement in its history. The State Administration of Foreign Exchange (SAFE) said that mainland investors would be allowed to invest directly in Hong Kong stocks via Bank of China’s Tianjin branch.

The so-called “through train” scheme bolstered the benchmark Hang Seng Index in Hong Kong and it staged a spectacular 1,000-point intraday rebound.

Subsequently Hong Kong shares went on a bull run, sending the index nearly 50% higher over the following two months, and reaching a historical high of close to 32,000 points.

But the through-train never left the station. The State Council overruled SAFE’s proposals on concerns that China’s capital controls weren’t strong enough to handle the strain. A crackdown on hot money flow was initiated and Hong Kong shares retreated into a bear market.

Sentiment in China was deflated too. Over the following year, the key Shanghai Composite index plummeted nearly 60% from its all-time high (6,124 points, also set in October 2007). It has since been stuck at close to 2,000 points, making China the worst performing market globally for several years (see WiC166).

However, after a seven-year wait, the through train dream seems to be working up a head of steam once more. A revised plan was announced in April for freer capital flows between the Shanghai and Hong Kong stock exchanges and analysts are predicting a rally in Chinese and Hong Kong stocks when the scheme goes live next month.

How will the through train work?

The scheme’s official name is the Hong Kong-Shanghai Stock Connect. Unlike in 2007, the plan wasn’t announced by SAFE this time round. Instead it was unveiled by Chinese Premier Li Keqiang, who told international delegates of the planned launch at the Boao Forum in April. Stock regulators in China and Hong Kong swiftly followed up with a joint statement giving more details to the investing public.

The biggest difference to the previous proposal is that two “trains” will be empowered by the Stock Connect. As such, the plan allows for a two-way flow of capital rather than just permitting funds to depart China for Hong Kong.

Up to 826 large and mid-cap stocks listed in Shanghai and Hong Kong are eligible for the trading programme. Investors in Hong Kong and overseas will be able to trade more than 560 Shanghai-listed stocks, although the total amount traded cannot exceed Rmb300 billion ($49 billion) a year, with a daily limit of Rmb13 billion (roughly equal to 15% of daily turnover in Shanghai).

Meanwhile, mainland institutions and “sophisticated investors” – individuals with at least Rmb500,000 in their brokerage accounts – are permitted to trade 266 Hong Kong-listed stocks (a fairly comprehensive grouping, since the firms account for 95% of the market capitalisation of the territory’s main board). Similarly, this southbound trading link is capped with a cumulative annual quota of Rmb250 billion, plus a daily ceiling of Rmb10.5 billion.

The trading limits will be reviewed after an unspecified trial period. (Beijing might be amenable to raising the ceiling if there is sufficient flow between the two bourses, China Securities Journal, a Xinhua-owned financial newspaper, reported this month in a front-page story.)

Revenue from the transactions will then be shared equally between the two exchanges: Hong Kong (HKEx) and Shanghai (SSE).

Regulators and brokerages at both ends of the Stock Connect have been busy conducting trial runs for the cross-border scheme, although no timetable has been fixed for its formal launch. But the Hong Kong Economic Times says that “investors are holding their breath for the big day,” as authorities hint that the Stock Connect could go live as early as mid-October, a timing that the state-run China Daily also confirmed this week.

Is it a big deal for Chinese stocks?

“During the month of October, you will be hard-pressed to find a more significant capital market development impacting not just Asia-Pacific but globally, than the Hong Kong-Shanghai Stock Connect programme,” FinanceAsia reckons.

Currently mainland institutions can only invest outside China via the Qualified Domestic Institutional Investor (QDII) scheme. As of June regulators had approved total QDII quota of $80 billion, with less than half is exposed to the Hong Kong market. Likewise, the A-share market in Shanghai is off-limits to most overseas investors apart from institutions signed up for the Qualified Foreign Institutional Investor (QFII) scheme, as well as a similar programme known as RQFII (which allows offshore renminbi to be invested in Chinese stocks and bonds).

The Stock Connect means that individual investors in Hong Kong and China will be able to trade shares listed in each other’s market for the first time. It has already sparked rallies in both markets. The Hang Seng Index has climbed nearly 20% since April, while Chinese stocks have bid farewell to the worst of their bear market too. The Shanghai Composite Index has gained nearly 10% so far this year.

Many analysts see further upside, like Mandy Chan from HSBC Global Asset Management, who believes that the Stock Connect could bolster trading volumes and turnover rates of Hong Kong stocks. She also notes that the A-share’s large caps tend to be cheaper than their Hong Kong-listed H-share equivalents (for example, the H-shares of ICBC, China’s biggest bank by market capitalisaion, trade at HK$5.21, or Rmb4.13. But the lender’s A-shares are priced at Rmb3.56, i.e. a 16% discount.)

“Some blue chips in the A-share market will likely attract overseas investors,” Chan says.

In the past only financial institutions with quotas in both the QDII and QFII schemes could arbitrage the pricing differences between A-shares and H-shares. With retail investors soon to be allowed to do the same thing, China Securities Journal expects that the price gaps, a legacy of China’s capital account controls, will start to narrow.

The standout performers in the pre-scheme surge have tended to be Chinese stocks listed not in Shanghai but in Hong Kong. Why? The Hong Kong Economic Times predicts that mainland investors will chase shares in companies that they know but which they have not been able to invest in previously.

One of the best examples: China Mobile has surged more than 50% since the Stock Connect scheme was announced. Tencent, which operates popular internet applications such as QQ and WeChat, is also expected to do well. It has climbed nearly 20% since April.

Also likely to be favoured are Hong Kong blue chips such as HSBC and the Li Ka-shing conglomerate Hutchison Whampoa, as well as possibly the casino operators in Macau. Another key beneficiary will be brokerage – given trading volumes are likely to increase.

Hong Kong Exchanges and Clearing – the listed entity that controls the territory’s stock exchange – could arguably be the most unique concept play under the Stock Connect – given the Shanghai Exchange isn’t listed. Investors concur with this view: the stock exchange’s shares have also gained 60% since the through train was announced.

More financial reforms to follow?

According to the China Daily, the total financial assets of mainland households amounts to Rmb65 trillion, of which only 12% is allocated to securities while 64% is parked in cash. (In contrast, American households invest 44% of their assets in stocks and bonds, keeping just 16% in bank savings.) Chinese regulators are now more comfortable in allowing freer movement of this massive cash pile, the state-run newspaper reckons. Additionally, by boosting demand for renminbi-denominated products from overseas, including shares and stock derivatives, the hope is that more of the Chinese currency will be used in offshore settlement.

“This is an important development to broaden the use of the yuan into the capital account channel,” declares China Daily.

The Financial Times agrees, suggesting that the Stock Connect programme is “a significant step in financial sector reform and the gradual easing of capital account restrictions”. The FT also points out that the scheme is following a pattern similar to other financial reforms in China, where the scope is narrow at the outset, and then increases gradually.

The speed of further deregulation, CBN suggests, depends on how quickly trading through the Stock Connect picks up. One way to pick up the pace would be to add more exchanges, for instance. The most obvious candidate is the Shenzhen Stock Exchange and indeed it announced last month that it was in talks with central authorities to have its own Hong Kong-Shenzhen Stock Connect scheme too.

So all is well for Hong Kong?

Most financiers in Hong Kong are happy to see the city maintain its position as the key international conduit for China’s financial reforms.

“The Stock Connect is further confirmation of China’s commitment to financial reform, and reaffirms Hong Kong’s rise as the fulcrum of China’s broader economic integration with the global economy,” Peter Wong, the chief executive of HSBC’s Asia-Pacific operations announced.

The Stock Connect puts Hong Kong front-and-centre in China’s financial liberalisation process. But any gratitude towards Beijing for this lucrative role has been overshadowed by a looming political crisis in the city. Some years ago Beijing promised that the territory’s Chief Executive would be chosen by universal suffrage from 2017 onwards. However, the Standing Committee of the National People’s Congress (NPC) last month restricted the scope of the planned reforms. In a move towards ‘controlled’ democracy, Beijing has insisted that no more than a handful of candidates will be allowed to stand for Hong Kong’s top political job and each will first need to win support from a majority of a 1,200-strong “nominating committee” stuffed with pro-Beijing loyalists and Hong Kong business elites.

This is exactly the kind of electoral procedure that Hong Kong democrats have opposed. Following the NPC ruling, organisers of the so-called “Occupy Central” movement (see WiC244) threatened civil disobedience, that could culminate in an effort to paralyse the financial district with mass demonstrations.

No date has been mentioned for the first full wave of “Occupy Central” operations, although activists have hinted that – like the through train – they could start happening next month.

“Investors have seen glimpses of a bull market,” the Hong Kong Commercial Daily notes. “But for many of them the Occupy Central movement remains a big uncertainty.”

In fact, officials in Beijing have been blunt in warning that political unrest will deter the Chinese government from relying on Hong Kong for its international financial skills. “Hong Kong is an important offshore renminbi centre, but the development of the business relies on the stability of its financial environment,” Vice Minister of Finance Wang Baoan told reporters in July.

One unspoken fear is that an angered Beijing might decide to postpone the Stock Connect plan next month, blaming Occupy Central for this act of retribution. Such a scenario might lead to investors stampeding out of Hong Kong stocks.

In the meantime, a large group of Hong Kong’s wealthiest tycoons are scheduled to visit the Chinese capital later this month to meet Chinese President Xi Jinping and discuss Hong Kong’s political future. Other business groups will follow. Clearly Beijing is hoping that their support will smooth the passage of the new electoral arrangements through the Hong Kong legislature next year.

Such uncertainties aside, there are some who are claiming the through train won’t be that big a deal for Hong Kong anyway. Bloomberg reported this week that a broker had surveyed mainland Chinese investors and found that 77% of those polled wouldn’t take advantage of the new scheme and purchase Hong Kong stocks.

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