25 April 2019
A cross-border stock trading program between Hong Kong and Shanghai is sparking concern over a potential liquidity squeeze in the offshore renminbi market. Photo: Bloomberg
A cross-border stock trading program between Hong Kong and Shanghai is sparking concern over a potential liquidity squeeze in the offshore renminbi market. Photo: Bloomberg

Liquidity conundrum of Hong Kong-Shanghai stock connect

The Hong Kong-Shanghai mutual market access program, also called Hong Kong-Shanghai Stock Connect, is expected to be launched soon. It is a quota-based two-way trading scheme that will allow global investors to access the onshore A-share market (via Hong Kong) and mainland Chinese investors to access Hong Kong-listed equities.

There is concern about a risk of liquidity squeeze in the offshore-renminbi (or CNH) market after the launch of the Stock Connect scheme. There is also confusion over the potential source of extra liquidity.

In terms of flow, the impact on CNH liquidity depends on the ultimate net northbound and southbound flows. In the short term, with improving foreign sentiment towards China, there may be more buying from Hong Kong in Shanghai (northbound flow) than buying from China in Hong Kong (southbound flow). Thus there may be a tightening bias on CNH liquidity.

However, as and when the flow reverses, CNH liquidity should increase. There is no a priori reason to believe that the flows would only be one-way up north on a sustained basis. So the impact of Stock Connect on CNH liquidity is indeterminate.

Under the current setting, there is a daily quota of 13 billion yuan for northbound net buying (and an annual cumulative amount of up to 300 billion yuan) and 10.5 billion yuan for southbound net buying (and an annual cumulative quota of up to 250 billion yuan).

If net demand is so strong that the respective daily quotas are exhausted every day, the annual quotas for both north and south bound flows will be exhausted in about 23 trading days; the program will then be suspended for the rest of the year.

In this case, the liquidity squeeze will be a one-time aggregate shock equal to the difference between the northbound and southbound annual quotas, or 50 billion yuan. This would still be less than the amount of excess RMB deposits in Hong Kong after accounting for the absorption by dim sum bonds.

For those who are expecting the People’s Bank of China (PBoC) to add liquidity to CNH, they will likely be disappointed as it is unlikely to happen. If the PBoC decides to keep the overall money stock constant, adding RMB liquidity to CNH requires a reduction in the onshore money supply by the same amount.

This is analogous to a sudden increase in Chinese savings (since the RMB that flows to Hong Kong under Stock Connect cannot be cashed out and spent under current regulations), which will hurt China’s economic growth.

Can the PBoC not create new money for CNH? Yes, it can, but it will not. Under the Stock Connect scheme, all RMB-HKD foreign exchange trades must be done offshore, in Hong Kong. This is clearly a move to keep the onshore CNY market ring-fenced from offshore development. In other words, Beijing does not care about CNH trading and fluctuation. It is encouraging on- and off-shore stock trading by using CNH liquidity only, while keeping the onshore monetary system out of the game.

Since the RMB is not fully convertible on the capital account, the PBoC will not automatically honor the excess demand for CNH by shipping CNY to Hong Kong. The only way Beijing will expand CNH liquidity under the current policy framework is via the 400 billion yuan swap line with the Hong Kong Monetary Authority (HKMA). However, even if the HKMA activates the swap line, not all of its liquidity is available for catering for RMB demand under the Stock Connect scheme because RMB trade settlement in Hong Kong is already soaking up a large part of it every year.

Hence, the onus of providing/obtaining extra liquidity CNH for the Stock Connect rests on the market players. Since offshore RMB is fungible, large banks with multinational operations can transfer RMB from their affiliates in other offshore RMB centers to the CNH market in Hong Kong catering for their customers’ RMB demand in case of a CNH liquidity squeeze. For those offshore centers that have clearing banks, currently including Singapore, South Korea, London and Frankfurt, the pool of offshore RMB supply can be augmented by the clearing quotas of the clearing banks.

In a nutshell, there may be a short-term tightening bias in CNH liquidity after the Stock Connect program is launched, but the ultimate impact on CNH liquidity is indeterminate. Barring any policy shift, the PBoC is unlikely to provide extra CNH liquidity just for the sake of Stock Connect, as it is an experiment for capital account convertibility and financial liberalization but not a policy goal per se.

Multinational banks with affiliates in different countries will be able to add to CNH liquidity in Hong Kong by channeling fungible RMB funds in their other offshore RMB centers to Hong Kong. Thus, the maximum amount of offshore liquidity that can be added to the CNH market in Hong King is the total offshore RMB pool in the different offshore centers, which amounts to approximately 1.3 trillion yuan, or 1.1 percent of China’s M2 money supply, plus the clearing quotas of the offshore clearing banks.

– Contact us at [email protected]


Senior economist of BNP Paribas Investment Partners (Asia) Ltd. and author of “China’s Impossible Trinity – The Structural Challenges to the Chinese Dream”

EJI Weekly Newsletter

Please click here to unsubscribe