Shanghai-HK Stock Connect opens new era in China's financial integration

Shanghai-Hong Kong Stock Connect opens a new chapter in China’s financial integration with the world, and will in time reshape the dynamics of global investment flows. 

Expected to launch next month, Stock Connect will for the first time allow mainland Chinese citizens to invest directly in foreign equities, and give global investors direct access to China’s stock market. 

Stringent capital controls have isolated China’s financial markets. Outward portfolio investment – domestic investment in foreign securities – amounts to only 3 per cent of gross domestic product in China, compared with 49 per cent in the United States. 

The contrast is even starker for inward portfolio investment – foreign investment in domestic securities. It’s only 4 per cent in China versus 86 per cent in the US. 

Stock Connect is a crucial first step towards narrowing those gaps. Initially the programme will only involve the stock exchanges in Shanghai and Hong Kong, and the two channels – northbound to Shanghai and southbound to Hong Kong – are subject to both a daily quota and an aggregate quota. 

But if history is any guide, the quotas will be increased and the programme expanded to include Shenzhen’s stock exchange and possibly other assets such as commodities, bonds and derivatives.

The implications are far-reaching. First, it will unleash China’s vast savings on the global financial markets. 

China’s citizens set aside more than half their income, making them some of the world’s most enthusiastic savers. But they have few investment channels. Bank deposit rates are capped. Many so-called wealth-management products lack transparency and returns from local stock exchanges have been subdued of late. 

One of the biggest incentives of Stock Connect is simple portfolio diversification. High-net-worth individuals in China invest only 5 per cent of their wealth overseas, while their global counterparts invest 24 per cent of their assets outside their home regions. 

Global portfolio investors have had limited access to the China growth story, and the hunger is out there. Turnover on the Hong Kong exchange has risen sharply since the announcement of Stock Connect, partly because investors are anticipating that substantial inflows will drive up the dual-listed shares once the “through train” is on the tracks. 

International markets have embraced the Renminbi Qualified Foreign Institutional Investor scheme. China has so far approved 84 overseas institutions as RQFIIs, utilising 250 billion yuan out of a potential 640 billion yuan of RQFII quota available globally – up from 20 billion yuan in 2011. But Stock Connect will offer a more direct channel to invest in China.

We also think there will be demand from international index investors. Once the Shanghai exchange becomes broadly accessible, it is only a matter of time that “A” shares are included in emerging markets indices such as the FTSE and MSCI, a move that will drive extra demand from exchange-traded funds.

Institutional investors are underrepresented on Chinese share registers. In China, retail investors’ share of market capitalisation is 83 per cent, while domestic institutional investors and foreign institutional investors are 16 per cent and 1 per cent. 

This is in sharp contrast to the emerging-market average of 35 per cent for retail investors, 39 per cent for domestic institutional investors and 25 per cent for foreign institutional investors. 

The shares of annual stock-trading volume tell a similar story. In China, retail investors account for 86 per cent of volume, while domestic and foreign institutional investors are 14 per cent. The emerging-market average is 45 per cent for retail and 55 per cent for domestic and foreign institutional investors. 

Finally, Stock Connect confirms the yuan’s status as a global investment currency. 

Cross-border use of the yuan has increased rapidly in recent years. Last year, 18 per cent of China’s trade was settled in yuan, up from 2 per cent in 2010. Capital flows in yuan have also been increasing and a vibrant dim sum bond market now sits outside China. 

With Stock Connect, the wall separating Chinese investors from their global compatriots is becoming lower. Though China’s size means that any loosening of its capital controls will matter for the rest of the world, the integration of China in global capital markets will lead to enhanced risk-sharing and liquidity. 

China’s financial opening-up to the world not only provides a new source of funding, but also will lead to a more diversified and stable global investor base. 

More international companies may choose to list in Hong Kong now that they can tap “southbound” Chinese capital. 

And in the future, initial public offerings in China may become global affairs as international investors, both institutional and retail, can “go north” via Hong Kong. 

Stock Connect marks an important page in the development of global capital markets. The “through train” will knock down the barrier between the Shanghai and Hong Kong bourses. It may even serve as an example for collaboration between other boards in the world. 

 

Gordon French is head of Asia-Pacific global banking and markets at HSBC.