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Stock exchange link may set the bulls runningUpdated: 2014-10-03 07:54

By Oliver Barron(China Daily Europe)

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As Shanghai and Hong Kong investment channels open, exciting times lieahead for China's capital markets

China is expected to launch Hong Kong-Shanghai Stock Connect, a schemethat will bring the Hong Kong and Shanghai stock exchanges together andallow mutual investment. With significant doubts hanging over the scheme sincethe outset, the fact that authorities are sticking to a timetable many believed tobe unachievable shows that Chinese policymakers are very serious aboutreforming the world's second-largest economy.

Under the scheme, mainland investors will be allowed to invest up to 250 billionyuan ($41 billion, 31 billion euros) in 268 Hong Kong stocks, while Hong Konginvestors will be able to invest up to 300 billion yuan in 568 domestic equities. Investment intoShanghai from Hong Kong will be capped at 13 billion yuan a day, and investment in the otherdirection will be capped at 10.5 billion yuan a day. It is the first time that domestic individuals willbe allowed to invest overseas.

Many policy priorities are supported by the introduction of Stock Connect. On a macro level, theChinese government is clearly trying to shift the financing of the economy away from riskier andopaque shadow banking toward the more transparent and regulated capital markets. In the firsteight months of the year, bond issuance rose 17.7 percent year-on-year to 1.63 trillion yuan, and

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equity financing rose 60.2 percent year-on-year to 242 billion yuan, the People's Bank of Chinasays. By contrast, loans from trust companies, a key driver of shadow banking, fell 73.3 percentyear-on-year to 393 billion yuan, while banker's acceptance bills, another form of off-balance-sheet financing, fell 59.7 percent year-on-year to 260 billion yuan.

While equity issuance has risen significantly, the fundraising size remains small relative to othersources of financing. China has no lack of companies wanting to engage in IPOs, with as manyas 600 companies lining up to list on the domestic exchanges. What has been lacking in recentyears has been willing buyers, as share prices have continually fallen since 2009 highs, andturnover has fallen, too. Introducing new foreign capital should help.

Without Stock Connect, the only way foreigners have been able to invest in the domestic marketis through the Qualified Foreign Institutional Investor scheme, which had an approval quota of$59.6 billion by the end of August, or roughly 365 billion yuan. Once the 300 billion yuan StockConnect quota is fully utilized, total foreign holdings of domestic shares will almost double.

The government is also trying to bring domestic investors back to the market. In the first week ofthis September Xinhua News Agency published at least eight long articles encouraging people toinvest in stocks. With the government expecting new inflows from foreign investors potentiallydriving up share prices, this is a clever strategy to make Chinese households a bit of money.

If markets rise first from domestic inflows and later from foreign inflows, it could lead to evengreater domestic inflows and push the Shanghai Stock Exchange even higher, the ShanghaiComposite Index being up by more than 14 percent since the end of June. While foreigninvestors' domestic investment is now capped at 300 billion yuan under the quota, authoritieshave said that both the list of investible securities and quota could be expanded. A virtuous cyclecould be created that would drive a new bull market for Shanghai equities.

Beyond the desire to boost transparent financing, bringing more money into the stock market isalso important for other domestic reforms. In particular, it should push forward the reform ofstate-owned enterprises, which authorities are trying to achieve through the capital markets. Oneof the main ways the government wants to reform SOEs is by introducing private investors andboosting corporate governance to drive efficiency gains. A number of SOE groups will be listedon the equities markets, and many SOE subsidies will be spun off and listed. Greater domesticliquidity supports this process.

It also benefits mergers and acquisitions in overcapacity sectors such as steel and cement. Inmany of the old industrial sectors markets will deteriorate as the economy rebalances andbecomes less reliant on fixed asset investment and more reliant on consumption and theprovision of services. The government hopes that these sectors can be restructured with M&Asthrough the equities markets.

Finally, Stock Connect should increase the attractiveness of holding renminbi overseas, forming

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Finally, Stock Connect should increase the attractiveness of holding renminbi overseas, forminga key support for China's internationalization of the currency. One thing that has held back thegrowth in renminbi assets overseas has been the lack of investment options, as renminbi holdersoverseas are limited to investing through RQFII funds or the dim sum bond market. Opening upthe mainland market to foreign holders of renminbi will boost attractiveness of renminbioverseas, which is important for the long-term policy goals of opening up the capital account andeventually seeing the renminbi become a reserve currency.

While Stock Connect clearly supports many policy goals, there are some who doubt it willsucceed.

In terms of flows of investment from Shanghai to Hong Kong, domestic investors are wary ofinvesting in a market they do not understand. A survey by the brokerage and investment groupCLSA Ltd in August showed that 77 percent of mainland investors would not take part in thescheme. Hong Kong shares are, on average, more expensive than their domestic counterparts,while many Chinese institutional investors that have experience investing overseas have lostmoney.

Meanwhile, there are two big issues that may discourage foreign institutional investors frominvesting in mainland shares.

First, under the original regulatory guidelines, investors who plan to sell shares must transferthem to a broker one day before they plan to sell. There are concerns that information could leakand other market participants could sell ahead of them, driving down the share price.

Second, a 10 percent capital gains tax may be applied to mainland investments through StockConnect that is not now applied to investments in Hong Kong. If this is done, investing in HongKong shares may be a more convenient way for international investors to get exposure to China.

While these concerns are valid, authorities appear to be aware of the problems and willing toaddress them. For example, Hong Kong Exchanges CEO Charles Li has said that investorswould be allowed to transfer shares to a broker by 7.30 am. If they wanted to sell those sharesthat day, shortening the time gap between the transfer of shares and actual sale.

Meanwhile, the Hong Kong exchange has reportedly asked China's tax authorities to giveinvestors time to adjust to tax rules, which would make investment more attractive. Furthermore,foreign investors may find it hard to avoid the fact that mainland stocks trade at a 5 percentdiscount to their equivalents in Hong Kong.

Chinese investors, meanwhile, will probably want to invest in well-known brands that are notlisted domestically.

Potentially attractive investments include Tencent, provider of the widely used mobilecommunications application WeChat, as well as the Macao casinos, such as Sands China and

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communications application WeChat, as well as the Macao casinos, such as Sands China andWynn Macao.

At the Third Plenum last year, President Xi Jinping said the goal of reform was to let the marketplay a larger role in the economy. A successful Stock Connect demonstrates that these were notjust empty words and suggests exciting times lie ahead for China's capital markets.

The author is head of the China office of London-based China economics research companyNSBO. The views do not necessarily reflect those of China Daily.

(China Daily European Weekly 10/03/2014 page10)

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