Hong Kong-Shanghai Bourse Tie-up on Track

On Oct. 13, the long-awaited “Shanghai-Hong Kong Thru-train” linking the Shanghai and Hong Kong share markets is expected to start to roll. Pilot runs started on Aug. 11, giving both markets a 1 percent bounce.

The decision to link the two markets has been on the cards since the October 2013 Third Plenum of the Communist Party and is very much at one with Prime Minister Li Keqiang’s vow to make the economy more market-oriented. It was triggered by the success of an experiment starting in April 2013 in which Taiwanese, Hong Kong and Macanese investors were allowed to open onshore brokerage accounts.By July, more than 30,000 such accounts had been opened, with their owners acquiring renminbi4.2 billion worth of A-shares through roughly 9,000 active trading accounts.

But at this point there it is questionable if voters know what they are celebrating. Big Bang this is not. The whole exercise, which began with the announcement of the thru-train on April 1, is an exercise in extreme caution. The pilot run imposes a limit on quotas for participation that in fact allows only big institutional investors to participate. What’s more, the regulation that no single investor could hold more than 10 percent of tradable shares of a listed company shows the administration’s concern about arbitrage activity and market volatility.

There are also limitations on the quantity of shares on the table. In northbound trading, only about 560 A-shares will be included among Shanghai Stock Exchange-listed securities, mainly the SSE 180 Index and the SSE 380 Index, which are constituent stocks of the Shanghai Composite Index.

It also appears likely that mainland investors will only be able to trade 266 Hang Seng Large-cap Index and Composite Midcap Index stocks. Beijing has also made it clear that thru-train trading is limited to the secondary market, while naked short-selling and security lending are prohibited.

But some players believe there is room for looser regulation. On Aug. 14, the Shanghai exchange released 50 more major amendments on rules and regulations concerning the thru-train, of which changes in wording deserve attention: IPOs were previously described as “forbidden” but are now “temporarily not considered”.

As explicit as the Chinese government always is, you can almost read it as “it will be considered” – if things do work out.

The A-share market has been strapped in a bear market since the 2008 global financial crisis almost halved its market capitalization, the memory of which haunts the mainland China stock market today, which is believed to be seriously undervalued.

A-shares are trading at 10.69 times earnings while H-shares are traded at 11.6 times. The leading shares on the A-share market are even more undervalued and trade at 6 times earnings. Investors’ loss of confidence in the leading shares pushes up short-term bets on themes and small plays. The S&P 500, for instance, currently trades at 18.5 times earnings.

Now with the coming of the in of Thru-train, investors are hoping that both markets would see a convergence of prices of the stocks involved.

There is another layer of the story. Institutional investors only hold of 10 percent of tradable shares on the A-share market against 61 percent of H-shares. Retail investors dominate the mainland market, though as individuals they are too frequently doomed by the volatility they build up collectively.

The thru-train raises expectations that the structure will be optimized and that the investment philosophy of the A-share market will come to predominate.

Linking the markets also raises hopes for additional internationalization of both.

But where there is hope, there is also the chance of disappointment. In May Morgan Stanley announced it would include the A-share index into the MSCI (Morgan Stanley Capital International), a significant measurement of equity market performance. Ultimately things turned sour simply because the A-share market is not open enough.

However, Beijing has already taken tentative steps to open the mainland market to the outside world preceding the onset of the thru-train. In QFII (Qualified Foreign Institutional Investor) and RQFII (renminbi Qualified Foreign Institutional Investor) foreign capital has been drawn into the Chinese bourse, although the scale is not as big as that of the thru-train.

“The A-share market is now basically a dead pool,” said Steve Wang, chief China economist at Hong Kong-based Reorient Group, Ltd. “QFII and RQFII brought in fresh streams into the pool. But thru-train – this could be a flowing river of foreign capital. This is a incremental yet historical reform.”

As closed as China’s financial market is, the thru-train seems an impressive step forward. But observers can be forgiven for expressing doubt about how far forward the step is.

The Southbound Aggregate Quota is set at renminbi 250 billion, while the Northbound Daily Aggregate Quota is set at renminbi 300 billion, 1 percent of the whole 30 trillion A-share market cap. Talking about percentages is always less exciting than talking about the money.

But probably less excitement is exactly what Chinese government wants, and it wants changes to happen incrementally and steadily. One of the signs for steadiness is that under the thru-train mechanism day trading on the A-share market is still forbidden.

“The Chinese government is sending a signal: ‘we still don't welcome market speculation, and we set all the limits and regulations to ensure everything is under control,’” Wang said, “it is planting the seed of change and carefully valuing how it goes. It is more of conducting an experiment rather than craving for the fruit.”

Strengthening the renminbi as an international currency is deemed as another ambition. With both stock markets clearing with renminbi, mainland investors will inject large amount of renminbi into Hong Kong markets, which at the same time will see a flood of foreign cash being exchanged into the renminbi for buys on the A-share market. It is a closed loop that pushes the currency’s internationalization yet minimizes the risk of fluctuations in exchange rate.

“Opening up of capital account is an one-way road, and coming along with it the rapid appreciation of the currency would be irreversible,” says Wang, “that’s why Chinese government would rather amble along.”

Expectations and hopes are not the only goods the thru-train is carrying to Hong Kong. It is also loaded with anxieties and doubts. When the launch of the Shanghai Free Trade Zone and Thru-train ignite the flame of liberalization in Mainland China’s financial market, people ask, how much time is left for Hong Kong to keep its superiority as a financial center or the only wholly free market feeding on the banquet of a not-so-free China, to be more explicit?

The truth is that thru-train will help Hong Kong to breathe. It is designed to strengthen Hong Kong as the biggest offshore renminbi business center, also as the cushion for currency exchange between Mainland China and the international capital market. But what’s next?

Trusts, futures and securities – such words reveal part of the essence of the financial markets. It is built on players’ confidence and expectations.

“Confidence comes from an accomplished legal framework,” Wang said. “It comes from an atmosphere created by professional and experienced bankers and traders. It comes from a faith that I would not lose my money tomorrow only because the government changes its mind. It is something that still takes its absence from Mainland China market, and something that would still keep Hong Kong prosper -- at least for a while.”

As for the future, he continues, “the only way out is to catch up with the high standards of London and New York in terms of financial services, which would not come without a better governance and a continuously advancing society.”

Anyhow, the thru-train is a clear signal of China’s resolution to further market reforms. Yes, the daily quota frees only 1 percent of the whole A-share pool. Yes, if you’re a mainland retail investor you won’t be allowed to participate without a balance of at least RMB500,000 in your stock account. And yes, margin trading and IPOs are still off the table. But under China’s political ecological environment, a signal itself always means more than the content.

Not saying that Hong Kong will get drenched in any minute, but better take an umbrella.

Chen Yajiao is an intern for Asia Sentinel