China grabbed all the headlines this past week. The much-anticipated equity trading link between Hong Kong and Shanghai goes live today. China's plan to create a Free Trade Area in the Asia-Pacific region was endorsed by all 21 countries at Asia-Pacific Economic Cooperation summit on Wednesday. And a trade deal between Washington and Beijing reached at the sidelines of the APEC summit the previous day was hailed as paving the way for the first significant World Trade Organisation agreement on technology tariffs in nearly two decades.
But the real exuberance in the investment community was over the surprise removal of the daily cap on the conversion of Hong Kong dollars into renminbi. The decision is widely seen as aimed at boosting market liquidity for the ground-breaking but much-delayed stock link between the Hong Kong and Shanghai bourses. The scheme – known as the Shanghai-Hong Kong Stock Connect or locally as the “through train” – provides mutual-trading access between the Shanghai and Hong Kong bourses. Trading goes live today (Monday).
The main action will be onshore
The main action – and volatility – will be in the A-share markets. Speculation that international investors will snap up local A-shares has already sent China’s domestic shares market to a three-year high. The removal of the HKD 20,000-a-day conversion cap on Hong Kong residents is a huge sweetener for the market – adding to offshore confidence that the government is solidly behind the project.
All cross-border equity investment until now has to be channelled through narrow institutional quota schemes. Stock Connect is portrayed as an opportunity that for the first time gives foreign funds direct access to Chinese stocks. Market bulls are already saying that the new trading scheme could pave the way for the inclusion of A-shares in global benchmarks such as the MSCI indexes with all that it implies for asset allocation.
Smart money, dumb money and arbitrage
Smart and dumb money alike has been piling into A-shares ahead of trading on Monday convinced that overseas exuberance willcontinue to push up valuations and that the Chinese government will ensure plenty of liquidity support for the market.
Excitement boiled over following the decision to scrap Hong Kong’s daily conversion limit. The Shanghai Composite Index rose 1% to 2,494 at close on Wednesday. Bloomberg data showed trading volumes up 12% over the 30-day average. Hong Kong’s benchmark Hang Seng Index advanced 0.55% to 23,938 on turnover of $74.39 billion. The CSI 300 Index, which is designed to replicate the performance of 300 stocks traded in the Shanghai and Shenzhen stock exchanges, advanced 1.4%.
Prices between China-listed A-shares and Hong Kong-listed H-shares have already started to converge. The largest renminbi-denominated stocks went from an 11% discount in July to a 2% premium this week, the priciest level in 14 months. And Bloomberg data shows that just 17 of the 68 dual-listed shares it tracks have lower valuations in Shanghai than in Hong Kong compared with 26 three months ago.
Arbitrage is the name of the game near term. The Shanghai index trades at 9.2 times estimated 12-month earnings while the H-shares measure has a multiple of 6.8. But the valuation gap between the two share classes will soon be eliminated as mutual trading starts. Then it will be a question of choosing the right stocks. Which stocks are over-valued, under-valued, fairly valued or simply too opaque to invest in is a subject well researched and commented on by many excellent sell-side analysts.
The Chinese face of greed and fear
But consistently falling below the radar of offshore investors is how local money perceives risk and reward. Greed and fear in China’s domestic equity market is driven by factors unique to its regulatory and political structure. It has been said – and not entirely in jest – that Chinese stock prices are more responsive to the circulation of political gossip than the circulation of money.
In an environment where market forces play second fiddle to administrative decisions, punters are always on alert for opportunities to profit from the intended and unintended consequences of policy and regulation. Currently the perception is that the government will do whatever is necessary to keep the Stock Connect scheme running smoothly, such as the scrapping of the daily conversion limit to boost market liquidity.
This is more than just a pilot program to connect two bourses. This is an experiment in allowing the free flow of billions of dollars every day between a hard-currency regime and a non-convertible one. How well it works is crucial to Beijing’s bigger game plan of removing capital controls down the road so that the renminbi can become a genuine global currency.
But investor sentiment can change – and in the A-shares market they can change overnight. Perhaps the project works too well in unintended ways. Perhaps transactions will show suspicious activities similar to the trade invoicing scam to dodge exchange controls that skews export numbers (See my article from October 16: Take China's export figures with a big pinch of salt). Perhaps regulators will decide to revise the allowable daily quota currently capped at $2.1 billion for Shanghai-bound investment and $1.7 billion for Hong Kong-bound investment. Perhaps policy micro-management kills off risk appetite.
Investors eyeing the Shanghai market would do well to remember that in China crunching spreadsheets provides just part of the investment story. The fundamentals could be spot on but the reality is that markets can be wrong for longer than an investor can remain liquid.
– Edited by Gayle Bryant
Pauline Loong is managing director of Asia-analytica Research and senior fellow of the CIMB ASEAN Research Institute. Follow Pauline or comment below to engage with TradingFloor.com's social trading platform.
Important notice: Nothing in this report is intended to be, or should be construed as, an offer to buy or sell, or invitation to subscribe for any securities or as advice relating to legal, technical or investment matters. This report has been prepared on the basis of information that is believed to be correct and from sources believed to be reliable. Asia-analytica makes no express or implied warranty as to the accuracy or completeness of any such information and makes no undertaking to update any such information. Opinions expressed are subject to change without notice.
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