24 October 2016
PBoC chief Zhou Xiaochuan is expected to unveil more monetary easing moves and financial reforms, providing new momentum to China-related stocks. Photo: CNSA
PBoC chief Zhou Xiaochuan is expected to unveil more monetary easing moves and financial reforms, providing new momentum to China-related stocks. Photo: CNSA

Why China stocks in HK have more upside

China is set to speed up capital market reform and capital account liberalization within this year, going by the pronouncements of the top leaders during the recent parliamentary sessions.

Zhou Xiaochuan, the central bank chief, meanwhile said during the Boao Forum that the government will undertake a thorough review of the foreign exchange regulations and laws as the nation has set a timetable for opening up the capital account.

The reforms will pave way for China to lure more global capital and help lower the financing costs for domestic firms.

In next six months, the government will roll out various measures such as Shenzhen-Hong Kong Stock Connect, expansion of investment quotas in the Shanghai-Hong Kong Stock Connect, and reforms related to A-shares IPOs. All these will inject more momentum into the Hong Kong market.

The stock connect with Shanghai and Shenzhen will pave way for the inclusion of A-shares into global stock benchmark indices, which would bring massive capital into mainland markets in turn. For example, the inclusion of A-shares into the MSCI emerging market index will bring additional US$150 billion into the mainland market. And A-shares could account for over 10 percent of the index.

MSCI will conduct a review of its global indices this June, which means A-shares could be added into its emerging market index as early as June 2016. However, the process could involve various preparatory work.

Currently, the AH premium index suggests that dual-listed H-shares are at 23.3 percent discount with A-shares. And the price/12-month earnings multiple of H-shares is still at 8 even after recent sharp rally, 22 percent below the average P/E ratio of 10.2 times over a 10-year period.

Meanwhile, the price/12-month earnings ratio of Hang Seng index is around 12 times, very similar to 10-year average. This means a significant discount over A shares, which have a P/E ratio of 14.9 times on average.

Given the large price discount, H-shares have become attractive for mainland institutional and retail investors.

Arbitrage trading between dual-listed shares is set to continue, as the AH premium index has already narrowed from 135.4 on March 27 to 123.4 at present. H-shares with large discount will become the biggest beneficiary of the stock connect.

The looming deflation risk in China may prompt the central bank to cut the reserve requirement ratio (RRR) another 25 or 50 basis points in the coming weeks. And the interest rate may also be cut by 25 basis points in next three months, while the RRR may be further reduced by 100 basis points in next 6 to 12 months.

Moreover, the central bank will step up liquidity measures like reverse repos, medium-term lending facility (MLF) and Standing Lending Facility (SLF) in the months ahead. Given all these factors, H-shares may continue to outperform other Asia markets and emerging markets in next 3 to 6 months.

Mainland banking plays have already priced in the negative impact of interest rate liberalization. Banks and insurance stocks have lagged behind small-cap stocks during the recent market rally, and are still traded at great discounts in the Hong Kong market.

Therefore, these stocks may have plenty room for valuation recovery, as monetary easing and financial reforms will reduce the systematic risk premium for mainland banks. And the capital market reforms will improve the investment outlook for mainland insurance companies.

Also, the move of allowing mainland mutual funds to invest in H-shares will benefit bluechip stocks that are not available in China. Hong Kong bluechips, mainland famous brands, private enterprises that are yet to be listed at home will be among the key beneficiaries. Stocks with huge price discount over A-shares will be particularly in demand.

This article appeared in the Hong Kong Economic Journal on April 13.

Translation by Julie Zhu

[Chinese version 中文版]

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Asia Pacific chief investment officer at Credit Suisse

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