After years of speculation, the date finally seems to be approaching. On April 22, a Shanghai newspaper reported that the China Securities Regulatory Commission (CSRC) had finalized a list of 10 multinational firms approved to participate in a pilot scheme that will see them list on the Shanghai Stock Exchange’s new international board.
If true, the move could prove a landmark for the slow but steady liberalization of the mainland’s financial system – including a more convertible currency, open financial markets and loosened capital controls.
It’s hard for Hong Kong Exchanges and Clearing (HKEx) to see this trend as anything but a threat. The stock market’s phenomenal success in recent years is directly attributable to its exposure to the China growth story – or, more specifically, to China’s growth and its largely closed financial system. The latter has been essential because it forces Chinese firms to use Hong Kong as a route to access international capital markets.
But as the mainland continues to deregulate, will the Hong Kong market sustain its appeal to mainland firms and investors?
“Shanghai is the place of choice,” said Frasier Howie, a managing director at CLSA and co-author of two books on China’s capital markets. “Hong Kong tries to define itself as an ‘international’ or ‘offshore’ center, but I’m not sure what exactly that means.”
At first blush, it may seem an odd time to question HKEx’s future: The Hong Kong bourse is arguably the most dynamic in the world. Some 114 initial public offerings generated over US$61 billion in capital in 2010, making HKEx the world’s largest IPO market for the second year running. That figure represents 24% of the global IPO total, and is almost double that of the world’s largest market, the New York Stock Exchange (NYSE).
Well over 90% of new listings over the past five years have been by mainland companies, including a series of blockbuster IPOs like China Construction Bank in 2005 and Agricultural Bank of China in 2010. Mainland firms – including those domiciled offshore – account for about 57% of total Hong Kong market capitalization, and around 67% of trading turnover.
Moreover, despite the dominance of mainland companies on its board, Hong Kong has largely escaped the accounting and corporate governance scandals that have plagued the US over-the-counter bulletin board (OTCBB) and Singapore exchanges. Many analysts see this as proof that HKEx has high standards and its investors are savvier regarding mainland companies – though cynics retort that the more likely reason is that rules effectively make shorting small-cap stocks impossible in Hong Kong.
The draw offshore
The first question that must be asked is why Chinese companies would forgo domestic exchanges to list offshore. All other things equal, the Shanghai and Shenzhen bourses are seen as preferable because offer listing companies more money. “A-shares [shares listed on mainland stock exchanges] of companies in traditional industries often have higher valuations than Hong Kong, [-listed shares] and that can sometimes be significant,” said Terence Ho, Greater China strategic growth market leader at Ernst & Young.
However, others argue that this pattern isn’t necessarily reliable enough; they suggest that Hong Kong’s primary attraction for mainland companies is not higher valuations but its comparative ease. The entire timetable of domestic bourse listings is determined by mainland regulators, which can be opaque and unpredictable.
“The queue for listing in China is very long, and the review and approval process in China is not entirely market-driven,” said David Ko, a Shanghai-based partner at KPMG. “Regulators adjust the pace of approval based on government economic policies and the performance of the exchange.”
While mainland firms also require approval from the China Securities and Regulatory Commission (CSRC) before listing on HKEx, that approval process is generally straightforward. Alternatively, some avoid the requirement altogether by first domiciling offshore – most often in the Cayman Islands, the British Virgin Islands, or Hong Kong itself – and then listing in Hong Kong. However, this so-called “red chip” route has declined in popularity because offshore restructuring is becoming increasingly complicated and expensive.
Mainland regulatory hassle doesn’t end after the IPO. Unlike Hong Kong, domestic exchanges require yet another round of approval before any further share issuance. This essentially means companies looking to raise more equity capital have to start at the back of the queue for CSRC approval. It can be a deal-breaker for fast-growing firms that reckon they might need to quickly raise capital to fund future expansion.
For companies looking to go global, funds raised in Hong Kong also successfully skirt the stringent capital controls of the mainland. “I think a major reason why Hong Kong remains the international listing of choice is because you can get your money offshore,” said CLSA’s Howie. “And that remains important. Cash is still a ‘Great Wall’ in China, and getting over it is important.”
The next question is why Hong Kong is preferable to other international bourses. The most immediate reason is geographic and cultural proximity, which engenders a level of comfort and creates a momentum effect.
“It is part of China, and everything about it is quite similar to the mainland. The language factor – prospectuses are bilingual – accounting, doing business, and so on,” said Ernst & Young’s Ho. “Investors and regulators just understand Chinese companies better, so it’s the natural first choice.”
This familiarity might help HKEx provide more accurate valuations. Ho says that except for the clear niche markets elsewhere – like NASDAQ for tech firms – Hong Kong is usually the best default for companies seeking a fair cost of capital. This is especially true for mid-cap firms, which might be more recognizable in Hong Kong than elsewhere.
Companies may also benefit from Hong Kong’s more balanced investor makeup. On the mainland, about 90% of investors are retail and 10% institutional. In the US markets the numbers are reversed, with institutions on 90
%. In Hong Kong, meanwhile, retail investors make up about a third of the total, with institutional investors accounting for the rest.
“All the shares of companies listed in Shanghai change hands once every four or five months. That’s too often – it’s speculative,” said Ho. “On the other hand, if markets are too dominated by institutional investors, you have stable share prices but less liquidity – investors could have problems finding someone to sell to. I think Hong Kong has a much better mix in this respect.”
Favorable geography and a good investor base give Hong Kong an advantage, but the competition is undoubtedly heating up. In October 2010, the Singapore Exchange (SGX) made a US$8 billion bid for the Australian Securities Exchange (ASX). Had it been successful, the deal would have created Asia’s fourth-largest stock exchange, using economies of scale to cut costs, boost liquidity and more effectively take on other exchanges. Just in case Hong Kong missed the message, the deal was marketed with the slogan: “Asia Pacific – the heart of global growth.”
The Australian Treasury ultimately rejected the proposed merger, claiming that it “would not be in the national interest.” But the potential consequences of the deal were still felt. “I think it really shook [HKEx] up,” said CSLA’s Howie.
Mainland firms generally plump for Hong Kong over Singapore because of the former’s proximity, more liquid market, and somewhat deeper financial services sector. But Singapore is aggressively developing its portfolio, with senior brass indicating that the exchange will soon roll out equity trading in multiple currencies and new derivatives products.
These products often play to the city-state’s strengths in the property and maritime sectors. In January 2010, the HKEx was accused by local politicians of “losing” Hutchinson Port Holdings (HPH) Trust, a spin-off of Hutchison Whampoa, a Hong Kong-listed conglomerate controlled by tycoon Li Ka-shing. The firm chose to list HPH Trust on SGX, because Hong Kong does not offer a business trust listing product. PCCW, a local telecom and broadband provider, recently lobbied HKEx and the Securities and Futures Commission (SFC) to allow a business trust listing of its telecoms business on the exchange, but was denied. HKEx officials say they are continuing work with the SFC to develop a new business trust product.
But the most important new products are renminbi-denominated. Analysts estimate that Chinese currency holdings in Hong Kong banks, which have been accumulating since 2009, currently stand at about US$69 billion. The territory has offered offshore renminbi-denominated debt since 2010 and its first renminbi-denominated IPO – the Hui Xian REIT – launched in April 2011. Despite a large amount of hype, the offering was priced lower than expected, which was blamed on a lack of liquidity.
Demand for the renminbi in Hong Kong has been strong on the back of widespread expectation that it will appreciate. Investors using the currency automatically lock in appreciation – thought to be around 4-6% annually – on top of any further gains that might accrue from the new financial products.
Others are less sure that the new products are significant. “They’re a complete sideshow,” said CSLA’s Howie. “Investors have [effectively] had access to renminbi exposure for decades. H-shares have underlying revenues in renminbi, so if the currency goes up, cash flow goes up, shares go up.”
Moreover, while Beijing’s favoritism will allow Hong Kong to have a short and medium term monopoly on offshore renminbi, a clear trend toward convertibility could mean this edge evaporates in the long term.
Perhaps recognizing this, HKEx is also looking to increase its attractiveness to Chinese companies by streamlining its accounting standards.
Previously all mainland companies listed on the Hong Kong exchange – dubbed “H-shares” – were required to prepare two sets of financial statements: one set calculated according to mainland accounting standards and approved by a mainland auditor; and another that adhered to Hong Kong standards, signed off by a Hong Kong auditor.
As mainland accounting standards converged with international norms, many saw this rule as a costly historical artifact. After much consultation, in December 2010 the SFC agreed to allow H-shares the option of using mainland accounting standards only and scrapping the Hong Kong auditor. Financial statements can now be signed off by one of the 12 mainland auditing firms approved by the Ministry of Finance.
Critics alleged that the move effectively cedes regulatory control from the SFC to mainland authorities, who will be charged with monitoring compliance. While all 12 of the approved mainland audit firms have branches in Hong Kong, serious questions remain about the operational quality of their mainland auditors.
But the bourse says that compliance costs for mainland firms will decrease, giving it a competitive advantage. “Hong Kong is so far the only destination that has given Chinese companies this choice. This may attract more mainland firms coming to Hong Kong to list,” said Winnie Cheung, chief executive of the Hong Kong Institute of Certified Public Accountants (HKIPCA).
At the same time, Hong Kong has been attempting to court more listings by overseas firms. Seven foreign companies launched IPOs on the exchange last year, and the number is expected to be far higher in 2011.
The most interested are natural resources companies. HKEx changed its rules last year to make it easier for firms to raise equity capital for natural resources discoveries – an entreaty to commodities players that are keen to have a listed presence in China, which has become a key source of demand.
Skeptics say that HKEx investors are less accustomed to valuing commodities firms than investors on more traditional natural resource exchanges, such as London, Toronto, Johannesburg and Sydney. They argue that the impending merger of the London and Toronto bourses will eclipse Hong Kong by offering superior liquidity and concentrating commodities traders.
Yet the strategy has borne some fruit. HKEx has already landed IPOs from commodities firms based in China, Mongolia, Russia, South Africa and elsewhere. Its biggest catch so
far has been the Swiss-based Glencore International, which is preparing for a US$11 billion duel listing in London and Hong Kong.
The exchange has also been aggressively marketing to luxury fashion and cosmetics firms in Western Europe. Here it offers two unique advantages. First, a Hong Kong listing offers marketing opportunities for brands looking to break into China, which is rapidly becoming the world’s largest luxury goods market. Second, HKEx offers them access to a growing pool of Chinese capital.
And here, too, the bourse is experiencing some success. Italian fashion giant Prada is set to list in June. This decision opened the door for many more high-end brand names: Salvatore Ferragamo, Coach, Samsonite and Ducati have all indicated varying degrees of interest in listing in the near future.
These foreign forays are encouraging because they diversify HKEx’s exposure to the mainland market and reduce its reliance on an IPO pipeline filled with Chinese companies.
But the importance of foreign listings shouldn’t be overestimated, according to Philippe Espinasse, a Hong Kong-based independent consultant and author of IPO: A Global Guide. “You look at the latest presentations by senior management and it’s all about internationalizing … but the reality is that it’s still very much China-focused,” he said.
Secure in the short term
Hong Kong is not necessarily fated to be sidelined if the mainland market liberalizes. “The advantage is not just in rules and regulation,” said Edmond Chan, capital markets partner at PwC. “There’s better infrastructure and investor experience. In Hong Kong you can always find experienced professionals and investors.” Other analysts note that the territory’s stronger rule of law may continue to attract investment away from the mainland.
Still, there’s no denying that the bourse’s remarkable growth has been due to its proximity to a rapidly growing economy with no other real channels for capital to easily move in and out. It continues to pour resources into road shows marketing itself as “China’s Global Financial Center.”
“I think a lot of it is how quickly China can open its markets,” said Espinasse. “Hong Kong probably feels the threat, including from mainland China, as the renminbi finally floats and as the international board in Shanghai becomes a reality.”
He notes that international bourses have resumed the consolidation drive begun in the years leading up to the global economic downturn. A raft of new low-cost, largely internet-based exchanges has squeezed their profit margins on traditional cash equities.
In many cases, these exchange mergers solidify existing monopolies and strengths – effectively creating exchange brands. A London-Toronto exchange would lock down the natural resources sector, a New York Stock Exchange-Deutsche Börse merger would dominate interest rate futures exchanges, and so on.
Many in Hong Kong are now realizing that the territory can remain “China’s Global Financial Center” only as long as the mainland remains closed. Were that ever to change, the bourse could face an existential crisis. “Hong Kong is becoming like any other exchange,” said Howie. “It’s struggling to define itself.”