22 August 2019
The Stock Connect provides the incentive for investors to increase their A-share exposure. Photo: Reuters
The Stock Connect provides the incentive for investors to increase their A-share exposure. Photo: Reuters

How Stock Connect will change A-share investing

The “through train”, or the Shanghai-Hong Kong Stock Connect, is finally leaving the station on Nov. 17. The scheme is another step in Beijing’s financial liberalization.

From an investment perspective, it has the potential to trigger a re-rating of A shares, prompting international fund managers to increase their buying of such stocks and boosting the odds for an A-share rally in the coming year.

There is a strong structural reason for investors to increase A-share exposure, and the Stock Connect provides the incentive to act. China is the world’s second largest economy with over 12.3 percent share of global GDP. It accounts for 11.3 percent of global trade, 23 percent of global fixed asset investment, and 7.9 percent of global consumption. Chinese equities listed onshore or offshore represent 10.5 percent of the world market capitalization, ranking second behind the New York Stock Exchange.

Yet, the weight of Chinese stocks in the MSCI AC World Index is only 2.2 percent. Global mutual funds have less than a 2 percent allocation in China, suggesting that global investors are significantly under-weighing China relative to its global economic influence.

The first phase of opening up the Chinese stock market to foreign investors came only in 2003 with the launching of the Qualified Foreign Institutional Investor (QFII) quota scheme. This program has been expanded in recent years along with the launching of the Renminbi Qualified Foreign Institutional Investor (RQFII) quota scheme in 2011.

Before the Stock Connect scheme, foreign investors can only access onshore China investments via the QFII or RQFII quotas. And outward investment by domestic Chinese investors has to be channeled via the Qualified Domestic Institutional Investors (QDII) quota scheme. All three licensed programs are only granted to institutional asset managers, and come with applicable restrictions such as quota caps, lock-up periods, fund repatriation restrictions, asset allocation rules etc.

Stock Connect is going to change all this by allowing onshore mainland investors and offshore foreign investors to bypass the QFII/RQFII/QDII restrictions and directly access Hong Kong-listed and Shanghai-listed shares without pre-approved licenses and quotas.

The program is open to institutional and retail investors on both sides, with the only limitation set for mainland Chinese investors who are required to keep a minimum trading account balance of 500,000 yuan onshore.

The scheme could be a game changer for investing in A shares. Earlier this year, MSCI announced its decision not to include China A shares in the MSCI Emerging Markets (EM) equity and global indices largely due to the investable and liquidity constraints linked to the QFII/ RQFII quota systems. FTSE has yet to include A shares in its equity indices for similar concerns.

Both MSCI and FTSE will revisit the A-share decision in their annual reviews in mid-2015. The Stock Connect program could be the solution that will prompt the global index service providers to include A shares in their indices.

First, Stock Connect will make A shares easily accessible to international investors. Second, A-share liquidity could increase significantly under Stock Connect. The scheme only has net-buy quotas for northbound (300 billion yuan a year and 13 billion yuan a day) and southbound (250 billion yuan a year and 12.5 billion yuan a day) trading. As long as the net-buy quotas are not hit, trading volume can increase for as large as the trading day allows.

The inclusion of A shares in global equity benchmarks will force a major re-weighting of global/EM portfolios, forcing fund managers to buy A shares to mark portfolio weightings to global benchmarks. Full inclusion of A shares into MSCI EM would raise China’s country weighting from 19 percent of the benchmark to 28 percent.

Similarly, the FTSE Group estimates that the combined onshore and offshore listed Chinese equities will have a weighting of around a third of the FTSE Emerging Index (adjusted for free-float and existing foreign ownership restriction rules).

In the short term, Stock Connect will co-exist with the QFII & RQFII schemes. Until the eligible Stock Connect investable universe is completely expanded, and until the northbound daily and aggregate quota caps are significantly relaxed, QFII and RQFII remain relevant for investing in Chinese onshore equities.

Over time, it is inevitable that the QFII and RQFII schemes will be displaced by Stock Connect. The new trading paradigm will remove barriers to entry, allowing asset managers to compete on a level playing field. Early entrants to play Stock Connect should benefit the most.

For foreign investors buying A shares through the scheme, consumer-related stocks and sectors that serve the large domestic Chinese market should be the most attractive. Liquor and dairy makers that do not have Hong Kong listings and high-dividend stocks are also expected to deliver outstanding returns.

For mainland investors buying Hong Kong stocks, the likely focus is on blue-chip stocks that offer unique market and sector exposure that does not exist in China, such as international insurers, telecom and technology companies and even the stock exchange of Hong Kong.

[Chinese version 中文版]

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

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