Shanghai-Hong Kong Connect: All Aboard the Through Train

 

Following its announcement in April, the launch of the Shanghai-Hong Kong Stock Connect (the “Connect”) is expected to commence in October. This will establish a two-way conduit for an ​initially limited amount of capital to flow between the two exchanges:

  • North: allow overseas investors access to most domestically-listed A-shares1 without going through the cumbersome application for quota as a Qualified Foreign Institutional Investor (“QFII”); and
  • South: allow domestic investors access to major H-shares listed in Hong Kong,2 creating a powerful link between mainland China’s capital base and Hong Kong’s internationally integrated financial system.

While a small step in China’s financial reform agenda, we feel this catalyst has significant implications for asset allocators globally:

 
  • The largest exchange outside the US. Combining the Shanghai and Hong Kong stock exchanges will create the third largest stock exchange after the NYSE and NASDAQ with $6Tn in traded market cap or 9% of the world’s total.3 For overseas investors this will add 855 $1bn+ Chinese companies to the investable universe as well as broaden the available sectors.4 For Chinese domestic investors, access to Hong Kong will allow them to invest in stocks not listed in Shanghai, such as the gaming names and even China Mobile.
  • Potential for more allocation and index rebalancing. Expanding this further, if global investors are better able to access China equity markets and allocate closer to China’s 13% share of world GDP,5the resulting inflows should create a strong bid for Chinese equities. For example, through H-shares, China’s present weight in the MSCI AC World is only 2.2% and if, as the market is hoping, A-shares are added, this could lead to substantial passive buying. Moreover, given the fact that most global investors are underweight China (largely for macro reasons) and many stocks are at historically low valuations, there is room for more buying pressure.
  • The A/H share trade. There are nearly 100 stocks, mostly State Owned Enterprises (SOEs), which are listed on both exchanges. Historically the majority of A-shares traded at a premium to H-shares. More recently, however, many – particularly the larger names – have been trading at a discount as domestic investors fled the onshore market. The A/H trade has become a favorite amongst hedge funds and post-announcement the two have converged. We do see ongoing opportunities in this trade as long as the shares remain non-fungible (i.e., not mutually interchangeable).
  • Expanding and simplifying the avenues for investment into China. Global investors have been traditionally limited to individually- and selectively-allocated and cumbersome QFII quotas when investing in mainland shares. The Shanghai-Hong Kong Connect to some extent overcomes this by allowing any investor with an account at a Hong Kong exchange member firm to invest (although there are aggregate quota limits).6 Assuming the Connect is a success, the size of these quotas is likely to grow.
  • Further internationalization of the RMB. Although the Connect was originally suggested by the Hong Kong Exchange as a means to keep itself at the center of investment in China, this initiative has been seized by the mainland authorities to “help promote the internationalization of the RMB” according to the China Securities Regulatory Commission. Investors will be able to use the fully convertible CNH currency as opposed to the restricted CNY.7 Alongside recent moves to allow the RMB to be traded in Singapore, Taiwan and London, among other financial centers, increased use of CNH can be seen as a stepping stone to further liberalization of the capital account.
  • Further down the road. If the Connect is successful, it is likely we will see more opportunities created: an increase in the number of securities available on both sides to include small caps and Shanghai-listed convertible bonds (arguably one of the cheapest asset classes in the world); granting of access to index futures and even short selling onshore; access for domestic investors to international stocks and so on.

The establishment of the Shanghai-Hong Kong Connect is one of many steps China must take to fully integrate its financial system into the global marketplace. While the near term impact may be muted and uncertain, global investors cannot afford to ignore the long term implications. We believe that this move will create increasedinvestment opportunities for hedge funds. As well as the A/H trade mentioned above, greater liquidity and additional reform should lead to a more fertile ground not only for long/short equity funds but eventually also for convertible bond, credit and fixed income players. Finally, the establishment of the Connect will hopefully lead the domestic tax authorities to clarify their stance on capital gains and withholding taxes for international investors.

1568 names representing 90% of market capitalization and 80% of daily turnover in Shanghai (Source: HKEx).
2266 names representing 82% of market capitalization and 78% of daily turnover in Shanghai (Source: HKEx).
3World Federation of Exchanges, August 2014.
4“SH-HK Connect: New regime, unprecedented opportunity,” Goldman Sachs, Sep​tember 1, 2014.
5World Bank 2013 GDP data, July 2014. Includes China, Hong Kong and Macau.
6RMB 13Bn ($2.1bn) in daily quota and RMB 300Bn ($49bn) in aggregate quota for the Hong Kong to Shanghai flows and RMB 10.5Bn ($1.7bn) in daily quota and RMB 250Bn ($40bn) in aggregate quota for Shanghai to Hong Kong flows.
7CNH is the offshore deliverable RMB traded in Hong Kong while CNY is the onshore non-deliverable RMB traded in China.

Philip Wong, CFA, CQF is an Associate Director and a member of PAAMCO’s Strategy Allocation Committee. Prior to joining PAAMCO, Philip worked for HSBC in investment banking. Philip received his BSc in Mechanical Engineering from the California Institute of Technology and his MBA from Harvard Business School.

David Walter is a Director in PAAMCO’s Portfolio Management Group based in the firm’s Singapore office. Prior to joining PAAMCO, David performed a similar role for KBC Alpha Asset Management. David graduated from Christ Church, Oxford, with an MA (Honours) in Modern History.

Pacific Alternative Asset Management Company, LLC (“PAAMCO U.S.”) is the investment adviser to all client accounts and all performance of client accounts is that of PAAMCO U.S. Pacific Alternative Asset Management Company Asia Pte. Ltd. (“PAAMCO Asia”), Pacific Alternative Asset Management Company Europe LLP (“PAAMCO Europe”), PAAMCO Araştırma Hizmetleri A.Ş. (“PAAMCO Turkey”), Pacific Alternative Asset Management Company Mexico, S.C. (“PAAMCO Mexico”), and PAAMCO Colombia S.A.S. (“PAAMCO Colombia”) are subsidiaries of PAAMCO U.S. “PAAMCO” refers to PAAMCO U.S., PAAMCO Asia, PAAMCO Europe, PAAMCO Turkey, PAAMCO Mexico, and PAAMCO Colombia, collectively. 

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