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The Shanghai-Hong Kong Stock Connect Program: A Damp Squib?

November 25, 2014

The long awaited Shanghai-Hong Kong Stock Connect Program is finally here. But is it living up to its lofty goals?

After several delays, the much-anticipated Shanghai-Hong Kong Stock Connect program finally kicked off last week. Dubbed a “through-train” across the border, the program is expected to lure a large number of investors to both markets.

For investors in the mainland, they can use the Chinese currency, Renminbi, to buy shares listed on the Hong Kong Stock Exchange; and for those based in Hong Kong, they can use their RMB deposit to buy shares on the Shanghai market. The total quota of the program is RMB 550 billion (RMB 300 billion for Shanghai, RMB 250 for Hong Kong); investors on both sides are also limited by a set of daily quota. Analysts estimated that the daily quota would be exhausted during the first few days once the program started.

However, the first trading day turned out to be an anticlimax—volume was much weaker and also very asymmetric: the daily quota for Shanghai stocks were used up, but mainland investors only used less than 20% of their quota for Hong Kong stocks. In the following days things became even more lukewarm: northbound and southbound investment both fell dramatically, and total transaction volume by the end of the week was only less than 10% of the quota.

But investors shouldn’t pay too much attention to the short-term results, says Zhou Chunsheng, Professor of Finance at Cheung Kong Graduate School of Business. A former member of the Planning and Development Committee at China Securities Regulatory Commission, the country’s stock market regulator, Zhou says that the Shanghai-Hong Kong Stock Connect program is an important experiment for the mainland stock market, which is on its course to become more open and market-driven.

By allowing more investors to participate in the Hong Kong market, Zhou says, the program is also an educational opportunity for retail investors in the mainland, who are usually more speculative than their peers in developed countries. On the other hand, overseas investors in Hong Kong now have more exposure to Chinese stocks—a crucial part of the internationalization of the RMB.

In this interview, Zhou explains in details how the program works and what it means to the reform and opening up of China’s capital market.

Q. In the first week of the Shanghai-Hong Kong Stock Connect program, we saw much more capital moving north than the other way around. Compared with Hong Kong investors, mainland investors seem to lack an appetite for shares in the Hong Kong market. Why?

A. It’s indeed a little surprising. But if you think about the mindset of mainland investors, it’s not so hard to understand.

Zhou Chunsheng, Professor of Finance, Cheung Kong Graduate School of Business
Zhou Chunsheng, Professor of Finance, Cheung Kong Graduate School of Business

Retail investors in the mainland are not very patient; they usually prefer quick and high returns and so they are more speculative. But this “through-train” program doesn’t give them that opportunity. It only grants them access to 260-odd stocks on the Hong Kong Stock Exchange (H-shares), which are mostly blue-chip stocks that perform quite stably. The regulators’ intention here is to manage risks, and that’s why they only allow mainland investors who have more than RMB 500,000 in their capital accounts to participate in the program.

The other reason is that a lot of mainland investors who are really interested in the H-share market have already opened accounts in Hong Kong through other channels[1]. So we didn’t see that many passengers on the southbound train.

Q. According to the media, some investors in the mainland were surprised by the higher-than-expected foreign exchange cost when buying H-shares. So when an investor buys a share and then sells it at the exact same price, he will lose 4-5% just because of currency conversions. What happened here?

A. It’s not entirely true. The way foreign exchange works in this program is that mainland investors will have to buy Hong Kong dollars first to buy H-shares. And when they sell, they have to exchange Hong Kong dollars they receive back into RMB. So there’s definitely a conversion risk here.

But investors need to know that the currency price they see in the trading system is just a reference price, not the final price. The final price is set by the clearing company (in this case it is China Securities Depository and Clearing Co. or CSDC) after the market closes. Because the actual conversion is not done spontaneously, CSDC purposefully overcharges investors by a certain percentage just in case the currency market moves against it during the day. Unless the market did move that much before the clearance happened, which is rare, the clearing company will refund investors the difference between the reference price and the actual price.

Therefore, the conversion cost is usually not as high as what it initially appears to be. But this trading system does involve foreign exchange risks, especially when the currency market is volatile.

Q. Overall, the program hasn’t been as popular as anticipated. Why?

A. I guess it will take time for investors to warm up. We don’t need to pay too much attention to the short-term trading volume. In general, I think positively of the program. It will help internationalize the Shanghai stock market (A-share market) and give mainland investors access to a better variety of assets.

This is also a good chance to get mainland investors exposed to the idea of value investing.

In addition, the Shanghai-Hong Kong Stock Connect program will help the Shanghai Stock Exchange learn from its Hong Kong counterpart. The experience is very important for the A-share market because eventually it’s going to become more market-driven like the H-share market is. But all of these things need time.

Q. What are the main differences between the two markets in terms of trading rules?

A. Except for small differences including trading hours and fees, the major differences are that in Hong Kong, investors can buy and sell the same shares in one day (T+0) while the mainland market only allows investors to sell the next day (T+1); in the mainland there’re price limit mechanisms that prevent a share from rising or falling too much, but in Hong Kong there’re no such limits.

Based on Chinese authorities’ attitude, I think the A-share market will gradually adopt the T+0 mechanism, which is used in most developed markets. Again, that’s why the Stock-Connect program is a very important learning experience for mainland regulators and investors.

Q. How can this program be improved in the future and benefit more investors?

A. I think the taxation policy is already quite beneficial to investors. In the next three years, there’ll be no income tax for retail investors in the mainland; and there’s temporarily no capital gain tax for Hong Kong investors.

The other issue is foreign exchange. Like we discussed earlier the cost is not as high as reported by the media. But I think the burden will be further relieved for mainland investors if they are allowed to hold the Hong Kong dollars in their accounts after selling their H-shares; then they would be able to reinvest the money in the market without having to convert it back to the RMB after each sale. The more frequent the conversion, the higher the cost for investors.

[1] According to Chinese law, mainland retail investors are not allowed to directly invest in the Hong Kong stock market. But in reality, investors can either travel to Hong Kong to open investment accounts, or invest with securities firms in the mainland that are qualified to invest overseas. Since investors are bound by how much RMB they can convert to Hong Kong dollars, they usually have to use money-laundering techniques to bypass China’s capital control system to move their money to Hong Kong.

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