Taking a slow and steady approach to China through Stock Connect

China is finally within reach with Stock Connect

November 2014

On November 17, China took a big step forward in opening up its capital markets with the Shanghai-Hong Kong Stock Connect program.

Amid stellar growth over the past three decades, the benefits of China’s CNY56.9 trillion1 economy have largely been beyond the reach of many global equity investors. This is set to change with Stock Connect.

As some investors and brokerages push ahead to harvest the opportunities of this groundbreaking initiative, it may be prudent to pause and take a 360 degree look at the many aspects of this program.

Getting to know Stock Connect

Stock Connect promises to be a direct lane for global investors to tap eligible domestic A-shares on the Shanghai stock exchange. It is also groundbreaking for China as mainland Chinese retail investors will be allowed for the first time to trade directly the shares of companies listed in Hong Kong.

Together, the Hong Kong2 and Shanghai3 stock exchanges have a combined market capitalization of US$5.5 trillion. In effect, the program creates an equity market that is ahead of Tokyo and London in terms of size.

Trading under the program will initially be subject to a maximum cross-border investment quota. That’s a relaxation of control over capital flows compared with the current system of licensing and pre-approved investment quotas.

For trades northbound to Shanghai there is an aggregate quota4 of CNY300 billion and a daily quota of CNY13 billion. For trades southbound to Hong Kong, an aggregate quota of CNY250 billion and a daily quota of CNY10.5 billion apply.

As with China’s previous initiatives on financial market reform, such as the Qualified Foreign Institutional Investor (QFII) and Renminbi Qualified Foreign Institutional Investor (RQFII) schemes, the investment quotas for Stock Connect will likely be increased in the future.

Such a bilateral securities trading arrangement may also be expanded to include the other domestic Chinese equity market, Shenzhen, and potentially the stock markets in Taiwan, Korea and Singapore. By then, trading may not be limited to securities. Fixed income, commodities, exchange traded funds and other asset classes may also come under the fold.

Stock Connect will have far-reaching effects on the region’s economy and global financial markets. As the program develops, it is expected to create a broader investor base beyond China and Hong Kong and, more importantly, facilitate the establishment of the renminbi, or Chinese yuan, as an international currency.

The challenges in a nutshell

Like any innovative financial initiative, the Stock Connect program as also poses some questions and challenges. Understanding the different operating rules and marketing practices, including the stock codes, corporate announcements and trading fees of mainland China’s A-share market must be a priority.

While the program offers direct access to the domestic Chinese market without any geographic or capital requirements — and is a new channel for all Hong Kong and overseas market participants, including RQFII and QFII holders to access China stocks — it doesn’t allow intraday trading and investors must also pre-deliver their orders.

Shares are settled on the same trade day and cash on a T+1 basis in the domestic Chinese markets, unlike the T+3 norm in developed markets (although Europe has recently shortened to T+2). Pre-trade checking means that shares must be allocated to the broker before trading starts, giving rise to counterparty risk.

Investors won’t be allowed to participate in initial public offerings under the program and the daily quotas may also dampen trading activity.

Investors must also have a clearer understanding of details on taxation on dividends and capital gains and the mechanism for collection of such taxes. Stock Connect investors are also subject to pay a monthly fee, in addition to the existing fees and taxes as local investors in the two markets.

The fact that all trades northbound to Shanghai will be settled in renminbi is another potential hurdle, in terms of currency risks, for global investors.

Harvesting the opportunities

To navigate this new market environment, investors may want to think through and seek efficient solutions in terms of equity trading and portfolios, foreign currency services as well as custody and settlements.

The Chinese capital market will open up further over time, including removing the limits on investment by foreign institutional investors. But it will be a long and challenging process. Charles Li, chief executive of Hong Kong Exchanges and Clearing Limited, the stock market’s operator, said as much in his official blog5 recently.

The constraints will come down as Stock Connect progresses and investors gain a better understanding of the risks involved with cross-border investments. The prospect of the program expanding to include Shenzhen and other regional stock exchanges will undoubtedly create new opportunities for investors to capitalize on China’s growth performance.

As Li points out, Stock Connect is a step forward. It will be the start of a long journey with China and an opportunity that many investors are unlikely to ignore.

1 China’s 2013 gross domestic product, National Bureau of Statistics of China. http://data.stats.gov.cn/workspace/index?m=hgnd

2 HKEx Factbook.

3 Shanghai-Hong Kong Stock Connect Information Brochure for Investors (Northbound Trading). http://www.hkex.com.hk/eng/market/sec_tradinfra/chinaconnect/Documents/Northbound_Flyer_e.PDF

4 Shanghai-Hong Kong Stock Connect FAQ for Investors. http://www.hkex.com.hk/eng/market/sec_tradinfra/chinaconnect/Documents/Investor_FAQ_En.pdf

5 Charles Li Direct. http://www.hkex.com.hk/eng/newsconsul/blog/blog.htm

 

As Stock Connect develops, it is expected to create a broader investor base beyond China and Hong Kong and, more importantly, facilitate the establishment of the renminbi, or Chinese yuan, as an international currency.