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August 24, 2016

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Mainland, HK markets develop closer links

AS part of China’s market reforms, a stock-trading link between the southern city Shenzhen and Hong Kong was recently approved.

Now everyone is comparing prospects for the Shenzhen-Hong Kong Connect with events surrounding the start of the Shanghai-Hong Kong Connect 21 months ago. Shenzhen-Hong Kong Stock Connect will allow overseas investors to trade stocks on the tech-heavy Shenzhen exchange and offer mainland investors access to small-cap companies listed in Hong Kong.

When the Shanghai-Hong Kong Connect began in November 2014, a raging bull was brewing. In the ensuing seven months, the Shanghai market surged more than 100 percent before a dramatic crash occurred.

Analysts said the Shenzhen-Hong Kong Connect is likely to be more benign.

“Some investors see the new connect as a key signal for the start of a new bull run and an upsurge in brokerage stocks,” UBS Securities said in a note. “However, we think the surge is unlikely to be repeated since current market conditions are completely different from those at the launch of the Shanghai-Hong Kong link.”

Back then, UBS noted, the market was driven by the central bank’s decision to cut interest rates and by heavily leveraged funds.

Since then, securities regulators have cracked down on margin financing, and banks’ wealth management funds are being restricted from investing in stocks, the Swiss-based bank said.

Outstanding margin financing — money investors borrow to buy stocks — stood at below 900 billion yuan (US$135 billion) last week, compared with a peak of 2.3 trillion yuan recorded in June 2015, just before the big crash.

“I think the Shenzhen Connect program is a good news, but the extent of this good news may not prop up the share market,” said Hong Hao, chief strategist at Bocom International Holdings Co.

Hong said further market advances will depend on more positive news from fundamental changes and sustainable liquidity improvement.

Although it may not be as sensational as the groundbreaking Shanghai-Hong Kong Connect, the new Shenzhen link will expand the investing universe for mainland and Hong Kong investors.

After the launch of Shenzhen link, 50 percent of stocks in A Shares, or 81 percent by market share, will be available to foreign investors through the two stock-connect programs, according to Robeco Institutional Asset Management.

The new program will give overseas investors access to 880 Shenzhen-listed stocks, including 270 on the main board, 410 on the SME board and 200 on the ChiNext board. Initially, the ChiNext board will open to institutional professionals only.

“The launch of Shenzhen Connect will offer international investors better exposure to the high-growth parts of China’s economy,” said Erwin Sanft, head of China strategy at Macquarie Securities Group. “Private enterprises and ‘new economy’ stocks make up 74 percent of eligible stocks in Shenzhen, compared with 38 percent via the Shanghai connect.”

Shenzhen’s market is dominated by sectors related to China’s ‘new economy,’ including information technology, healthcare, consumer discretionary and advanced materials.

Shenzhen stocks in general posted annual profit growth of around 15 percent in the past three years, while the actual earnings growth of Shanghai stocks has slipped to negative territory in 2015, according to UBS.

High valuation

Still, analysts expected lukewarm mainland-bound trade in the initial stages of the new link because of the relative high valuation of Shenzhen shares.

“Shenzhen-listed stocks still trade at a trailing price-to-earnings ratio of 40, compared with 14 on the Shanghai exchange,” said Gao Ting, head of China strategy at UBS Securities. “We believe the demanding valuations of most Shenzhen-listed stocks will daunt many international investors.”

Goldman Sachs’ China strategy team pointed to higher risks of investing in Shenzhen than in Shanghai because Shenzhen stocks are more speculative, with a retail ownership ratio of 59 percent, compared with 34 percent in Shanghai.

Prospects look better for Hong Kong-bound trading.

“The Shenzhen Connect is likely to boost both positive sentiment and flow to the Hong Kong stock market as mainland investors look to Hong Kong to diversify assets,” said analysts at Robeco. “It will renew interest in Hong Kong-listed small caps, particularly in the stocks that were newly included.”

For mainland investors, Shenzhen Connect will provide access to 115 constituents of the Hang Seng Small Cap Index, on top of the existing 318 stocks available for trading via Shanghai connect.

Mainland participation in Hong Kong-listed shares has been increasing, amid yuan depreciation expectations and a strong appetite for high-yielding stocks. More money has flowed to Hong Kong through Shanghai Connect this year than the amount of funds coming via Hong Kong.

“Many institutional investors, including insurers and mutual funds, have participated in the program this year, boosting mainland investors’ share of Hong Kong stock turnover to 10-15 percent in recent months,” said Gao of UBS.

“The desire of mainland investors to buy offshore assets remains strong, especially with no Qualified Domestic Institutional Investor (QDII) quota being approved since April 2015,” he said. “Therefore, we expect active southbound trade via stock connect.”

In the recent announcement, the securities regulator abolished aggregate quotas on both of the connect programs. A daily quota is still in place, with 13 billion yuan in daily northbound and 10.5 billion yuan daily in southbound allowed for both programs.

When the Shanghai Connect was launched, it was subject to an aggregate quota of 300 billion yuan for northbound trade and 250 billion yuan for southbound trade. Before the abolition, 50 percent of the northbound quota and 82 percent of the southbound quota were utilized.

“The removal of total quotas shows that the authorities have confidence in cross-border capital flow management,” said Hong of Bocom International Holdings Co.

Shanghai-based fund consultancy Z-Ben Advisors sees it all as another step along the road toward quota-light cross-border access to China.

Participants in the Qualified Foreign Institutional Investor program in China are no longer subject to fixed investment quotas, after the Chinese regulator in February relaxed rules.

Investment quotas for qualified overseas financial institutions to invest in the country’s interbank bond market have also been scrapped.

“All of the China access programs are moving in one direction — toward quota-light access,” said Z-Ben in a note. “The QFII reform domino fell in February, the interbank bond market in March and, as the connect domino falls, we believe that the Renminbi Qualified Foreign Institutional Investor program will be next to be adjusted sometime soon.”


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