The Through-train To Chinese Equities

October 5, 2014

By: Ryan Aubert

Current economic data points to continued weakness in the Chinese economy and has reinforced concerns that China may miss its target growth rate of 7.5% this year for the first time since the Asian financial crisis. Sluggish domestic demand and a cooling property market continue to drag on the performance of the world’s second largest economy. Despite these concerns, the recent Alibaba IPO on September 19th, which raised a record setting $25 billion with share prices surging 38% in the first day of trading, demonstrated that investors still hunger for new opportunities to access the Chinese market.

Currently foreign investors have a limited ability to invest in securities listed in China directly due to its strict capital controls. Existing regulations restrict foreign investment in stocks on the Shanghai exchange to foreign currency denominated B shares, while only those approved under the Qualified Foreign Institutional Investor program are permitted to invest in yuan denominated A shares. This will begin to change this month with the introduction of a new program called the Shanghai-Hong Kong Stock Connect, which is expected to launch on October 27th. The pilot program will allow any foreign investor to buy and sell 570 different A shares listed in Shanghai directly for the first time. Additionally, Chinese investors with at least 500,000 yuan in their securities accounts will be able to buy 266 different H shares listed in Hong Kong using yuan through mainland brokerages.

Although the new program is big step towards the freer movement of capital in China, change will be incremental. Quotas will cap the flow of funds from Hong Kong to Shanghai at 13 billion yuan a day and at 300 billion yuan in total. From Shanghai to Hong Kong, the flow will be limited to 10.5 billion yuan a day and 250 billion yuan in total. These limits are net, so when one investor sells, another can buy. Trading volumes are likely to exceed these caps, particularly from Hong Kong to China.

Chinese officials hope that this timely reform will inject up to US$48-billion of foreign money annually in China and increase use of the yuan as a global currency. If the program is successful, a similar exchange could connect Hong Kong and Shenzhen, allowing for greater access to equity investments in China’s start-ups. The new link is also seen to carry numerous risks for investors. Concerns over whether trades and stock ownership will be accurately tracked, compliance issues related to the regulatory and legal differences between Hong Kong and Shanghai and rampant insider trading all contribute to fears that the new system will be vulnerable to exploitation and error.

Nevertheless, considerable excitement over the Stock Connect program exists and it can be attributed to anticipation that this is a first step in the liberalization of the entire Chinese financial market. While access to China’s US$3.7 trillion equity market is coveted by investors, Aaron Woolner of notes, “the corporate bond and commodity derivative sectors are the real prize.” Having overtaken the US last year, China now has more outstanding non-financial corporate debt than any other country, according to Standard & Poor’s. It is the prospect of access to the onshore bond market that has investors salivating.

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