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December 1, 2014

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Stock Connect comes up short after initial hype

THE new and much-hyped trading link that allows Shanghai and Hong Kong investors to trade equities on one another’s exchanges got off to a lukewarm start last month, but analysts remain optimistic about its potential to catalyze a profound change in China’s shielded capital market.

The Shanghai-Hong Kong Stock Connect, first unveiled in April amid great fanfare, enables offshore investors to directly trade Shanghai-listed companies without going through the tightly controlled quota systems. It also offers investors from China’s mainland direct access to companies listed in Hong Kong.

Expectations were running high that the link would produce some dramatic results at the start, turning on a tap for foreign capital to flow into China’s US$4.3 trillion stock market. In anticipation, the Shanghai Composite Index rose 18 percent in the six months preceding the debut.

However, reality has written a different script.

On November 17, when the link went into operation, investors from Hong Kong exhausted the 13 billion yuan (US$2.1 billion) daily quota allocated for northbound trading. However, the days that followed days took some of the shine off the debut, with the utilization rate slipping to around 20 percent of the available quota.

On the other side, uptake from mainland investors has been hovering below 2 percent of the 10.5 billion yuan daily allowance for southbound trading.

The somewhat disappointing figures came even after mainland authorities announced a temporary tax exemption on profits made from link trading, hoping to entice global investors eager to buy Chinese stocks directly.

Investment bank Nomura Securities Co said the slow start could simply reflect lack of investor familiarity with the new trading system.

“It could also be attributed to conservative northbound institutional investors who have yet to take on board the stock connect program due to operational considerations regarding clearing and settlement dates,” the bank wrote in a note.

Then too, the traditional discount of yuan-denominated Class A shares in China to their Hong Kong-listed counterparts narrowed prior to the start of link trading, souring offshore investor appetite for arbitrage.

The Hang Seng China AH Premium Index, which tracks the average price difference of A shares traded in China and Chinese company H shares traded in Hong Kong, moved from 89 in July to 102 last month as mainland investors snapped up cheaper A shares prior to the arrival of foreign investors. A figure above 100 indicates A shares are trading at a premium to those of the same company listed in Hong Kong, and a level below 100 signifies a discount.

Meanwhile, market watchers said northbound trading has been dominated by institutional investors largely transferring capital from the Qualified Foreign Institutional Investors system to the link system rather than bringing in fresh funds. Hong Kong stock exchange data showed that northbound trading was highly concentrated on a few Class A shares favored by QFII funds.

“This could underscore that international asset managers are gradually shifting their investment channel to Stock Connect because it is easier to transfer capital across the border and there is no lock-up period,” HSBC Global Research said in a note.

For southbound trading, analysts attributed thin volumes to lack of participation by institutional investors because it takes time for domestic mutual funds to roll out new products.

However, mainland retail investors, who account for 80 percent of the turnover in the A-share market, were also deterred by higher trading costs, exchange-rate risk and a minimum asset threshold of 500,000 yuan slapped on investors who want to trade Hong Kong shares.

As of October, according to the China Securities Depository & Clearing Co, only 5 percent of mainland retail investors had portfolios that large, leaving the remaining majority unqualified for the link.

Shares of Hong Kong Exchanges & Clearing Ltd have dropped nearly 9 percent since the link debuted as volumes signaled weak demand for Hong Kong and mainland equities.

Too early to judge

However, Wang Hanfeng, an analyst with China International Capital Corp, said it’s too early to judge the effectiveness of the new system

“The tie-up of the two markets provides only an additional channel for liquidity and does not change market fundamentals,” Wang said.

Despite the recent link-induced rally, mainland stock markets are still dogged by China’s prolonged economic slowdown, corporate earnings risks and initial public offering backlogs.

Wang said when the fundamentals get better and the trading mechanism of the exchange link improves, the new trading system will find favor with investors.

Currently, the cross-border program is limited to 568 selected stocks listed in Shanghai and 268 Hong Kong-listed shares. It allows 300 billion yuan of Hong Kong investment in the mainland and 250 billion yuan of mainland investment in Hong Kong.

The Chinese securities regulator earlier indicated those constraints may eventually be removed once the system has gained traction and is running smoothly. The Shanghai Stock Exchange has said it is considering the reintroduction of a day-trading mechanism — a move that would put it on a more equal footing with trading rules on the Hong Kong bourse.

Apart from bringing in fresh funds, many market watchers see far-reaching implications for link trading.

“The link shows China’s determination to open up its capital market,” said an analysis from Citigroup Global Markets Inc. “It provides a significant two-way investment opportunity for investors and will promote the convergence of investment philosophy toward a more balanced focus on growth, value and dividends.”

Chen Li, chief China equity strategist at UBS Securities, said mutual market access has largely increased the possibility for some important index companies, such as the MSCI, to include A shares in their international indexes next year.

That should heighten the awareness of major international publicly offered funds and potentially attract more investment, Chen said.

UBS estimated that the market capitalization of A shares held by international investors may increase from the current 350 billion yuan to 900 billion yuan in a year or so, accounting for 8 percent of free-float A-share market capitalization.




 

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