As we've noted, foreign investors until recently had two basic ways to get China exposure: either buying Chinese companies with shares that trade on foreign exchanges, or buying Chinese companies listed in Hong Kong. That left the universe of mainland Chinese stocks -- A-shares listed in Shanghai or Shenzhen -- inaccessible to foreign investors. A-shares now represent the fifth-largest equity market in the world, with about $3.9 trillion of total listed market capitalization (compared to Japan, for example, at $4.6 trillion).
China began opening the A-share market to outside investors in a very limited way in 2003, with a program that allowed in a few large institutional investors, each granted a quota for stock purchases. The number of approved institutions and the total quota granted have been rising steadily; there are now about 300 approved institutions and funds, with a total quota of about $83 billion. (Still small compared to the A-shares’ total market cap.)
A New “Through Train”
In 2007, the Chinese government proposed a “through train” whereby foreigners would be able to buy A-shares through Hong Kong brokers. That plan was never implemented, but it did contribute to a speculative bubble in Hong Kong equities. Nevertheless it remained a policy goal of the government.
In April of 2014, Chinese Premier Li Keqiang announced a new policy, the “Shanghai Hong-Kong Connect.” This time the policy was actually implemented, with trading commencing in November. The scheme permits trading in both directions -- a northbound trade whereby Hong Kong brokerages can buy A-shares for their clients, and a southbound trade whereby mainland investors can buy certain Hong-Kong listed stocks. Each direction has a daily quota, and if it reaches that quota, no further buy orders will be accepted. There are also aggregate quotas -- if those were reached, the government would have to approve an increase for buying to resume. The scheme effectively gives the government some “brakes” for the train.
The aggregate northbound quota is currently about $50 billion, and the southbound about $40 billion. The daily quotas are about $2 billion in each direction. So this scheme is a very substantial expansion of the old quota program for institutions.
Southbound Trade Picks Up
At first, the excitement was all about the northbound trade, with foreign investors very happy to be able to buy the ongoing A-share rally. Trading quickly reached its daily quota. However the southbound trade started as a “ghost train,” with little activity. This was due to the restrictions on which mainland buyers had access to the system -- initially, access was open only to those who could hold about $80,000 in a brokerage account.
Mainlanders wanted access, but few could get it. They wanted it in part to diversify, but largely to arbitrage the price differential between Hong Kong and Shanghai listings -- often, the same company would sell at a multiple of 11 in Hong Kong and 19 in Shanghai.
That lack of access changed dramatically on March 27, when the government announced that mainland mutual funds would be allowed to buy Hong Kong-listed shares. So mainlanders without the means to open an $80,000 brokerage account could now get access to Hong Kong through local mutual funds. That led to a strong rally in Hong Kong shares (comprised mainly of real estate and financials) and in Chinese shares listed in Hong Kong, the Hang Seng China Enterprise Index, or H-shares. That effect will likely be temporary, as Hong Kong-listed and Shanghai-listed shares converge in valuation -- although foreign investors will still raise demand for Hong Kong stocks and H-shares as they seek a less volatile way to ride the A-share rally.
The Ongoing Story
As we've noted, we believe that the current A-share rally (i.e., the northbound trade) is the real story -- and that rally is most fundamentally about actions being taken by Chinese regulators to boost the mainland stock market. The A-share market is not a market that trades on fundamentals, but rather on a psychology largely driven by the regulatory environment. Mainland Chinese households currently have 72 percent of their assets in real estate and 6 percent in equities; for U.S. households, those numbers are about 25 percent each (including pensions). The Chinese government has many reasons to deleverage the property bubble and encourage more public ownership of stocks… including its far-off, long-term goal (which may not be reached for years) of having a yuan which competes with the U.S. dollar and the euro as a global reserve currency.
While that goal remains, it’s likely that just as with the initial opening of the A-share market 10 years ago, we will see quotas and demand gradually expanding. (The Chinese government likes to act in a controlled and gradualist fashion with reforms.) We will probably also see an expansion of the Connect to include access to Shenzhen -- “China’s NASDAQ,” where the most expensive and most volatile Chinese stocks trade.
Investment implications: The Shanghai-Hong Kong Connect has helped propel rallies in China -- in A- shares, in H-shares, and in Hong Kong stocks. We believe the government’s support will continue, and we will be buyers of this rally in the various Chinese stock markets until we see evidence that government policy is shifting.