Investors in Shanghai grumbled loudly in early April 2011 when British bank HSBC Holdings said it would yet again delay a listing in the city. The state of the market, one of the world’s worst performing major equities exchanges that year, was simply not ready to absorb an international IPO, the bank’s Asia head implied at the time.
After 10 years of mulling over the concept, HSBC’s decision to back out of a mainland listing blackened the prospects for a long-awaited “international board,” on which local officials envisioned major global firms directly accessing China’s capital markets for the first time. Since then, international listings on the mainland have been all but dropped from conversation.
Any international firm still considering a Shanghai IPO on the international board may have finally abandoned such thoughts earlier this month when the China Securities and Exchange Commission and the Securities and Futures Commission of Hong Kong said in a joint statement that they would open a cross-border investment channel between their exchanges.
The scheme, known as the Shanghai-Hong Kong Stock Connect, will grant qualified investors in the two markets access to some shares on the opposite side of the border. Mainland institutional investors with more than RMB500,000 (US$80,000) in their trading accounts will have an aggregate trading quota of US$40 billion to buy up Hong Kong shares on the Hang Seng large and medium cap indices; investors in Hong Kong will have a trading quota of US$48 billion to buy into firms on two of the Shanghai Stock Exchange’s biggest indices, the SSE 300 and SSE 180. ‘Connect,’ as it’s come to be called, should launch within six months.
Firms such as European consumer goods giant Unilever, which also expressed interest in listing in Shanghai, will find navigating that opaque regulatory environment increasingly unattractive when it can access mainland capital via a listing in Hong Kong, one of the biggest and most efficient IPO markets in the world. The news should also cheer up the red-eyed mainland investors disappointed by the delayed international board. Connect will grant many of them the access to the strong firms in a solid regulatory environment they’ve sought out for years.
Market watchers have lauded the stock connect as a breakthrough in China’s capital markets. Hong Kong, too, can expect its prestige as a hub for fund management to grow with its extended reach northward. Given the increased amount of renminbi that will be allowed to move offshore, the scheme is also a sign that Beijing is pushing forward with internationalizing its currency.
But there are worries as well. The dimming prospects for an international board could set back the reputation of the mainland market and its regulator. Some analysts see funds in the two-way investment pilot mainly moving southward into the better-performing and more sophisticated Hong Kong market.
The game is Shanghai’s to lose – if mainland regulators cannot update and reform the local bourse quickly enough to convince domestic investors that it is the best place to generate returns.
“If the Shanghai market cannot catch up, it will inevitably result in a two-tiered market,” Raymond Yeung, a senior economist at ANZ Bank, said from Hong Kong. “The Shanghai market will be the second tier.”
This time around
This isn’t the first time the mainland has proposed a cross-border investment experiment. In 2007, the State Administration of Foreign Exchange said on its website that qualified investors could set up accounts at a Bank of China branch in Tianjin’s Binhai special economic zone. The notice said those investors would get limited access to the Hong Kong market, where shares rallied on the expectation of a wave of incoming investment. The plan, though, was never carried out.
“The ‘proposal,’ if it can be called that, was more of a pet scheme from Tianjin mayor Dai Xianglong, an ex-PBOC governor, as a way to enhance the city of Tianjin’s credentials as a financial center,” Fraser Howie, the author of several books on the mainland stock exchange and formerly the manager of a mainland-bound investment fund for investment bank CLSA, said in an email. “It never got anywhere near implementation and I think it was only taken seriously by [Hong Kong].”
This month’s announcement is different, Howie said. The joint statement from both the CSRC and the SFC shows that the two sides are serious about the plan. In 2007, details such as quota volume and timeframe were never divulged. Regulators on both sides of the border have included far more information in this statement.
“It could easily have been a much less detailed announcement from the exchanges talking about co-operation,” he said. “But clearly someone, somewhere, has been given approval to talk about billions of dollars of quota at this early stage.”
Big quotas to fill
Connect will fall into direct competition with China’s original cross-border investment programs. The Qualified Foreign Institutional Investor scheme, or QFII, allowed foreign investors to access China’s capital markets starting in 2003. The Qualified Domestic Institutional Investor program, known as QDII, which lets mainland investors access capital markets abroad, followed in 2006.
The quota for QFII has jumped from just US$30 billion in 2011 to US$150 billion last year. However, the program, known for its burdensome paperwork, has struggled to attract investors, with only US$53 billion, or little more than a third of the quota, allocated for investment in 2013, according to consultancy Z-Ben Advisors.
The poor performance of QFII is directly related to the performance of the Chinese stock market. The Shanghai Stock Exchange has languished during the past five years. Poor corporate governance has led to numerous fraud cases and investors have routinely lost out on hyped-up IPO prices that eventually plummet. Regulators have failed to clean up the mess.
In November 2012, the CSRC stopped approving new IPOs in the hope of cleaning out bad companies from the listing pipeline. Some 900 capital-starved companies were lined up for approval in the summer months of 2013. The implicit ban persisted for more than a year before about 50 firms were allowed to list starting this January. Regulators started the year with promises to make it easier for companies list and boost legal oversight for listed firms but investor confidence, including that of foreigners with QFII quotas, remains low.
At US$48 billion, the inbound stock connect quota is much smaller than the quota for QFII (however, it is very close to the size of the QFII quotas that are actually allocated). Mainland securities analysts were mixed on the impact the new plan would have on the older system.
“I think the influence on QFII will be limited,” said Yan Yijin, an analyst at Chief Securities in Beijing. Demand for mainland shares could be sluggish given the state of the market, she said. The original program’s international status should maintain some demand for those quotas. “QFII isn’t just investment from Hong Kong. It’s also used in Europe and the US. Connect will be limited to Hong Kong.”
Cao Yu, an equities analyst at Avic Securities in Beijing, downplayed the initial impact the program will have on mainland brokers, stressing that more details are needed. The model between Shanghai and Hong Kong, if successful, could be replicated between the mainland and other international exchanges in the future, but the government has yet to give any signs that it will do that, he said.
Mainland brokerages that deal in QFII or QDII will need to prepare for a change in the kind of services they offer, said Fu Jing, a Wuhan-based analyst at Changjiang Securities. “The companies should go to expand their scope of operations,” she said. Specifications for the plan, especially those concerning the requirements for taking part, have yet to be issued. Secu
rities companies will have to wait for clearer directions before they can respond, Fu said. “We don’t have the details yet. We don’t know what kind of system this is going to be.”
Plug the leak
A few details beyond those provided in the early April announcement have emerged. Some media reports say the investment system will be a “closed loop,” meaning that money Hong Kong investors put into mainland firms will not be allowed to flow into the real economy in China, instead remaining locked into the securities market. Last week, regulators on both sides on the border published more details on how they will monitor the capital flows.
Surprisingly, China’s central bank has yet to weigh in on the new plan or demonstrate how its policy will support Connect or prevent capital leakage.
“I haven’t seen any opinions from the PBOC on how this will connect to overall monetary policy,” Yeung at ANZ said. “Is it compatible with monetary policy? This doesn’t seem so apparent yet.”
Making sure Connect doesn’t open another hole through which hot money flows into China will be essential for the central bank. PBOC and China’s customs officials have been fighting an uphill battle for years against currency speculators who have bet on the slow, one-way appreciation of the renminbi. Traders in China often inflate the value of their exports when shipping to partners in Hong Kong, allowing them to bring extra yuan into China. On top of what was once thought to be guaranteed appreciation against the dollar, the hot money could be invested in high-yielding money market funds or even real estate developments.
Such arbitrage has skewed export data for more than a year. However, since early February, the People’s Bank has fought back by pushing down the value of the renminbi. The currency hit a 16-month low against the dollar in April prompting an abrupt halt to the practice that caused exports in February to plummet by 18% from a year earlier.
Without close coordination between securities and monetary policymakers, the Shanghai-Hong Kong Stock Connect is another worrisome channel for currency speculation. There’s no definitive answer on how the program could be used for financial arbitrage just yet but Yeung said the use of a company’s shares that are listed in both Shanghai and Hong Kong as a form of collateral could open up a channel for hot inflows.
“I think the real concern from the mainland is hot money going into real estate,” Yeung said, further fueling property speculation and the possible formation of bubbles in one of the country’s most sensitive sectors.
Damaged goods
The CSRC may be concerned with how its experiment could open the country to hot inflows in the short term. Likely greater on the minds of the top decision makers at the regulatory body are long-term concerns over the performance of the mainland exchange, especially after Connect opens it to greater competition with the outside world.
The program will, in effect, be Shanghai’s shortcut onto the global financial scene. Whether that’s good or bad for the long-term development of mainland equities market is up for debate.
It certainly won’t help the development of an international board in Shanghai. Once mainland investors get access to companies listed in Hong Kong, the listings of global companies will become the “de facto international board,” according to ANZ Research. International businesses will have little incentive to wet their feet in the Chinese market before its regulatory and corporate governance problems are cleaned up.
“I think if the Shanghai regulatory environment can catch up or meet international standards that will be a plus,” Yeung said. “But if they fail to do this, that might actually be a drag on the development of the market. Companies will prefer to list in Hong Kong … Investors will take advantage of better infrastructure and better corporate governance and the overall high quality of the Hong Kong stock exchange.”
The outbound quota for Connect is lower than the inbound, revealing some fears on the potential for a flight of capital from the mainland.
The Shanghai-Hong Kong Stock Connect isn’t an all-powerful antidote set to solve the problems the mainland has faced for a decade. In the end, the onus of bringing a greater level of transparency to the local market and boosting corporate governance at Chinese companies still falls on the regulators, whether it be the CSRC or China’s judicial arm, which has been far too lax on rule-breaking firms.
“If you open a shop and sell goods, but these goods are of dubious quality, bringing in more customers to your shop may generate more business, but it won’t improve the quality of your goods,” said Kevin Lai, a Hong Kong-based economist at Daiwa Capital Markets. “They need to change the whole investment landscape in China … Then there may be more interest in the mainland market.”