Connecting the dots

For more than a century Jardine Matheson was the most powerful firm in Hong Kong. But the British hong’s undisputed leadership position was shaken in the early 1980s, when Margaret Thatcher began talks with Beijing to return the colony to China.

There had already been signs of a shift in power when local Chinese businessmen took on Jardines for control of Hongkong Land – at the time the biggest property firm in the city by market capitalisation.

The hunting herd was led by an ambitious group of local real estate developers. They spotted Jardines’ vulnerability – it was exercising control but had less than a 30% stake in its property flagship – and so secretly accumulated a sizeable chunk of shares in Hongkong Land themselves. The stock price surged as a result and in the corporate drama that followed, Jardines mounted a desperate defence. It kept its real estate crown jewel but only by repurchasing Hongkong Land’s shares at a hefty 30% premium. That included buying up the stock held by the rival developers to fend off their unsolicited interest.

Richer and hungrier, the local tycoons returned to haunt Hongkong Land again in 1987. The takeover this time was fronted by the so-called ‘Guangdong gang’, including Li Ka-shing and Cheng Yu-tung (both were born in Guangdong province and are now two of the richest men in Asia). The consortium of Chinese tycoons again sought control of the most valuable land bank in Hong Kong’s central business district. And once again Hongkong Land fended off the takeover attempt by repurchasing its shares (including the stakes owned by Li and Cheng).

As part of the agreement, the Chinese businessmen promised not to buy any shares in a Jardine Matheson company for seven years.

Fast forward to present day Guangdong and the province’s most iconic developer China Vanke has also found itself in a fierce M&A battle. The saga unfolded after Baoneng, a young property-to-insurance conglomerate, amassed more than 20% in Vanke which, similar to Hongkong Land in the 1980s, was vulnerable thanks to a fragmented shareholding structure.

Baoneng’s boss Yao Zhenhua is also a Guangdong native. He even shares the same hometown in Shantou with Li Ka-shing. As WiC has pointed out, the business networks of Chinese businessmen are often quasi-tribal, with birthplaces playing a cohesive role. Some think this raises the prospect that Baoneng could copy the Guangdong gang’s hostile bid three decades ago by bringing in new firepower from several of the Shantou-born tycoons. More interesting still, a major regulatory change – the Shenzhen-Hong Kong Stock Connect – was announced this month that will allow Hong Kongers to invest directly in Shenzhen stocks. That means that some of the very same Hong Kong tycoons could take a more active part in the unfolding drama at Vanke, just over the border in mainland China.

What is the Shenzhen-Hong Kong Stock Connect?

The programme allows investors in Shenzhen and Hong Kong to buy shares in each other’s stock market. The much anticipated scheme was finally given the green light by the central government last week.

Shenzhen Connect will be the second cross-border stock purchasing arrangement, following a similar link with Shanghai (originally known in Hong Kong as the ‘through train’, see WiC252).

“The Shanghai-Hong Kong Stock Connect has withstood its market test, with steady and orderly overall performance. The programme has achieved its expected targets, earning positive feedback from all related parties,” Chinese Premier Li Keqiang said in a statement.

The premier didn’t give a launch date for the latest programme, although Charles Li, chief executive of the Hong Kong bourse HKEx, said that Shenzhen Connect could go live before Christmas, after final preparatory work that is expected to take up to four months.

There are roughly 1,800 listed stocks in Shenzhen and it is the busiest exchange in Asia, with a monthly trading volume worth more than $1 trillion. Foreign investors including those in Hong Kong will be allowed to invest in 880 Shenzhen stocks, including 270 on the Shenzhen Stock Exchange’s main board, 410 on the Small and Medium Enterprise bourse and 200 on the ChiNext. Meanwhile, up to 417 Hong Kong-listed stocks will be eligible for trading from Shenzhen. Other securities such as exchange trade funds (ETFs) could be included, albeit more likely in 2017.

That means that more investment options are available via the Shenzhen Connect than in the earlier Shanghai scheme, in which 567 A-share companies and 318 Hong Kong-listed firms were included in the stock connect.

A daily quota will likewise apply to cap two-way capital flows: Rmb13 billion ($1.95 billion) for the northbound route from Hong Kong to Shenzhen and Rmb10.5 billion for the opposite southbound traffic.

However, there will be no aggregate annual quota for the Shenzhen Connect (the overall limit for the Shanghai Connect – which amounted to Rmb550 billion – was also scrapped last week).

“Removing the aggregate quota should give institutional investors more confidence that the A-share market is open for investment on a large scale,” HKEx’s Li wrote in CBN, a mainland Chinese newspaper.

Li added that the daily quota remains in place because of “risk management considerations” but that it has effectively doubled in size.

Is China ready for the further opening of its capital markets?

The decision to remove the aggregate limit seems to have signalled that regulators have become more comfortable that the trading schemes won’t serve as a channel to funnel capital out of China.

Before the Shanghai Connect, cross-border investment in Chinese stocks was only allowed under several tightly regulated schemes such as the QDII and QFII, where institutional investors had to apply for approvals and an investment quota on a case-by-case basis.

The Shenzhen Connect – which was anticipated to go live much sooner – was put on hold after last summer’s market meltdown, which saw A-shares slump more than 40%.

The turmoil prompted a slew of interventions by Chinese regulators to prop up the market (WiC295). It also roused concerns over China’s ability to keep its financial system stable. In the wake of some of the more heavy-handed moves, global investors’ interest in Chinese stocks dropped sharply.

By giving the Shenzhen Connect the green light a month ahead of the high-profile G20 leaders meeting in Hangzhou, Beijing seems to be demonstrating fresh intent to open up the Chinese markets.

“The roll-out of the Shenzhen-HK Stock Connect after the Shanghai-HK stock link marks another concrete step for China’s capital market in becoming more law-based, market-oriented and global,” the official Xinhua news agency proclaimed.

According to the Financial Times, it is also another step towards getting A-shares included by MSCI, the world’s biggest index provider. MSCI decided against including Chinese stocks in its indices earlier this year (WiC329).

Opening more gateways to international bourses seems to be a natural extension to the Shanghai and Shenzhen arrangements. Both London and Singapore have been working to establish similar trading links with Chinese markets. London is probably the primary contender as a leading offshore renminbi trading centre, China Daily reported last month, although the Brexit vote may have prompted Beijing to take a wait-and-see approach before introducing a trading link with the London Stock Exchange.

Will the Shenzhen Connect top the Shanghai link?

The battle between Shenzhen and Shanghai to become China’s leading bourse has been a storied one. It even led to scandals in the 1990s when both the bourses were caught manipulating their turnovers so as to outperform each other (see WiC236).

Given this history, the Shenzhen government has every incentive to make sure the Shenzhen scheme fares better than Shanghai’s.

The central government gave Shanghai a two-year head start over Shenzhen as an outlet to promote cross-border capital flows. But the response so far has been lukewarm. The southbound Rmb10.5 billion daily quota has only been entirely filled a couple of times since the programme started. And investors have taken up only half the aggregate trading limit under Shanghai Connect.

Analysts generally agree that the Shenzhen Connect could fuel greater interest from both Hong Kong and mainland Chinese investors. “The geographical proximity between Shenzhen and Hong Kong actually makes it far easier for investors to move capital between the two cities,” Hong Kong Economic Times said.

Moreover, Shanghai is heavily skewed towards financial stocks – such as the state banking giants – which mostly have also gone public in Hong Kong. There are fewer dual-listed stocks and overlapping industries between Hong Kong and Shenzhen.

“The Shenzhen Stock Exchange, especially the ChiNext board, offers more complementary industry-level exposure compared to that of the Hong Kong market, such as software, high-end manufacturing equipment, hardware and healthcare,” Steven Sun, head of Hong Kong and China Research at HSBC, wrote in a recent report.

Hong Kong Economic Times noted that there are 400 more eligible stocks in the Shenzhen Connect than the Shanghai-Hong Kong trading scheme, and that most of the extra investment options are small-cap stocks in Hong Kong and high-growth stocks in the NASDAQ-style ChiNext in Shenzhen.

That seems to be exactly what many average punters have been looking for. “Not all retail investors want to invest in a banking heavyweight and sit on a 5% [dividend] yield,” the newspaper claimed. “The Shenzhen Connect is likely to fuel momentum of small-cap stocks in Hong Kong and Shenzhen.”

If the Shenzhen Connect can generate enough cross-border capital flow, it may help it achieve something that Shanghai Connect has failed: bridging the valuation gap between dual-listed shares. For instance, the A-shares of Bank of China remain 18% pricier in Shanghai than its Hong Kong-listed equivalent.

“There was speculation the gap would narrow with the launch of Shanghai Connect, but that didn’t happen,” HKEx’s Li suggested. “Long term, the gap will likely converge as stocks become fungible and investors have more options.”

Will the scheme’s launch complicate the Vanke takeover?

As WiC discussed last month, corporate takeover battles are relatively new to the Chinese share market (see our original story on the Vanke bid in WiC308, plus a more recent update in WiC336).

Admittedly, there are few concrete signs that the Hong Kong tycoons will take part in Vanke’s takeover saga. All the same, the Shenzhen Connect seems to have come at an intriguing time.

Indeed, the battle over the control of the Shenzhen-listed developer intensified the same day that the Shenzhen Connect was given the formal go-ahead. In a stock filing China Evergrande (formerly known as Guangzhou Evergrande) said it had raised its stake in Vanke to 7%. That made the rival property player the third biggest shareholder in Vanke, behind the aggressive Baoneng and the state-owned China Resources. To complicate matters further, Vanke’s management has been trying to bring in the metro firm backed by the Shenzhen government as a major shareholder and an ally.

Evergrande is now the second largest developer in terms of home sales in China, just behind Vanke. Its stake in Vanke is worth about Rmb18 billion and, according to China Daily, Evergrande has already earned a 40% trading profit on its position.

That offers some symmetry with the successful raids on Hongkong Land’s shareholding more than a generation ago. Regardless of Evergrande’s ultimate intentions, its boss Xu Jiayin may well be seeking advice from some of his Hong Kong allies, including the heir of Cheng Yu-tung, the Hong Kong property tycoon who was one of the masterminds behind the hostile bid for Hongkong Land in the 1980s. Cheng’s firm is a long term investor in Evergrande and his New World Group sold seven mainland property projects to Xu’s firm for $3.2 billion last year. “The question now is what role, if any, Evergrande will play in the prolonged takeover battle for China Vanke,” the Wall Street Journal opined. “Evergrande says its stake is an ‘investment’ but could it turn into a power grab?”

Should Evergrande decide to make an audacious bid for its bigger rival, the Shenzhen Connect may help in clearing the way for a few of Xu’s Hong Kong allies to join the fray. They have about three months to plot before the link becomes active…

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