24 August 2019
Investors should beware the hype surrounding Stock Connect. Photo: Bloomberg
Investors should beware the hype surrounding Stock Connect. Photo: Bloomberg

Why expectations for Shanghai-HK stock link are exaggerated

The market’s performance shows that enthusiasm for Shanghai-Hong Kong Stock Connect has waned after its debut on Monday.

The cross-border trading scheme has the potential to change A-share investing in the long term (as I argued earlier in this space), but its benefits have been overhyped.

Now the exaggerated expectations are coming back down to earth.

One of the major misunderstandings about Stock Connect is that it is a major step toward opening up China’s capital account.

This is wrong. It is not a big step forward, since it does not allow for full hedging activity to enable maximum market efficiency, as some major market players have told us.

Consider this. Hong Kong investors buying stocks interlisted in Shanghai can sell those stocks only in Shanghai. They are not allowed to buy stocks in Shanghai and sell them in Hong Kong to arbitrage the price differences.

The same restriction applies to mainland investors trading Hong Kong stocks. Thus, there is no effective price convergence or maximum market efficiency.

This is hardly a major step toward capital account convertibility.

The Stock Connect scheme only extends the boundary of Beijing’s control over capital in the mainland to Hong Kong. It does not really open up China’s capital account to allow free capital (out)flows.

This is because mainland Chinese investors who have bought Hong Kong stocks and sold them to take profits (or losses) must remit the proceeds to China. They cannot cash out and use the funds in Hong Kong or transfer the funds to other countries.

Hence, the billions of yuan flowing to Hong Kong through Stock Connect remains locked in a closed cross-border loop.

The same restriction applies to Hong Kong investors, who must move their money back to Hong Kong once they take profits or losses in the onshore A-share market.

Another major misunderstanding is that the scheme is a big move toward capital market liberalisation.

This is wrong again. It would be incorrect to compare the Stock Connect quotas with those of the Qualified Foreign Institutional Investor (QFII) and Renminbi Qualified Foreign Institutional Investor (RQFII) schemes.

The latter schemes allow foreign investors to buy up to a prescribed amount of mainland stocks and bonds, while the Stock Connect quotas allows investors to trade mainland and Hong Kong stocks until the net buy quotas in Hong Kong and/or Shanghai are reached.

These are totally different quotas, both on a theoretical and on an operational basis.

Incorrect comparisons like these have led some analysts to argue that the liquidity pools for mainland and Hong Kong stocks could improve significantly, as “it took 12 years and three years, respectively, for the QFII and RQFII quotas to grow to the current levels of US$58 billion and 258 billion yuan, while the Stock Connect scheme would allow an annual quota of 300 billion yuan for northbound buying and 250 billion yuan for southbound buying from the beginning”.

This is hype rather than solid analysis.

Now consider this. In addition to the annual net-buying quotas for northbound and southbound, there is also a daily quota of 13 billion yuan for northbound net buying and 10.5 billion yuan for southbound net buying.

If both daily quotas are exhausted every day, the annual quotas will be exhausted in 23 trading days; the scheme will then be suspended for the rest of the year.

Since investors don’t have perfect information on when these quotas will be reached, there is a significant execution risk – you just do not know how much of your order will be or will not be filled.

Finally, the regulation calling for all foreign exchange trades to be done in Hong Kong is aimed at insulating the onshore exchange rate from offshore market volatility.

This has the same purpose as ring-fencing the A-share market from offshore volatility by barring investors from the cross-border trading of interlisted stocks. An investor who bought Ping An in Hong Kong, for example, cannot sell the shares in Shanghai through Stock Connect, and vice versa.

These restrictions prevent full hedging and price convergence by limiting liquidity and asset flows between Hong Kong and Shanghai.

There are definitely benefits, and profits, to be had from the Stock Connect scheme, and it is a step forward toward financial liberalisation, deepening internationalisation of the renminbi and creating onshore-offshore market convergence.

But expectations about the pace of change and the delivery of results should be realistic.

– 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”

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