27 October 2016
Mainland money sparked a much-needed rally in the Hong Kong stock market, but it also brought unwanted volatility and mystery. Photo: Bloomberg
Mainland money sparked a much-needed rally in the Hong Kong stock market, but it also brought unwanted volatility and mystery. Photo: Bloomberg

Is mainland money turning HK stock market into a playground?

Welcome to the circus.

Special effects firm Digital Domain (00547.HK), a remnant of a bankrupt US Hollywood company, rose 1200 percent for no valid reason. It then crashed 60 percent after one of its bondholders was reported to have been arrested on the mainland — also not a valid reason.

Hanergy Thin Film Power (00566.HK) lost 50 percent in one second, wiping out over US$15 billion of shareholder value. Goldin Financial Holdings (00530.HK) and Goldin Properties (00283.HK) took a full two days to plunge 50 percent, but together erased US$22 billion.

And during a single week, Yan Tat Group (01480.HK) rose from HK$30 to HK$102 and then plunged to HK$7.5 in what former Securities and Futures Commission chairman SFC attorney Anthony Neoh labeled as a mainland pump-and-dump scheme.

Yes, they’re Hong Kong stocks. But their trading antics seemed to come straight from the mainland: wild, inexplicable price swings; rapid, indiscriminate buying and selling of glamorous companies without consideration for economic fundamentals.

It’s not surprising: The money that moved them likely came straight from the mainland, too — even if, ironically, the extreme daily price moves that wouldn’t have been possible on the mainland can happen in less-restricted Hong Kong.

But the real risk to Hong Kong and its investors extends beyond the volatility of a small group of stocks. Mainland investors — 95 percent of whom are individuals, and less than 20 percent of whom attended college — have virtually no other place to go with their money. Hong Kong’s equity investors — 65 percent of whom are institutions, and with the majority of those being foreign — have plenty of choices besides Hong Kong.

But mainland money seems here to stay, and the wrong response by Hong Kong could leave it as a volatile playground of mainland money — lacking the growth of its northern neighbor while also losing the trust and stability that made it Asia’s financial capital.

Easy come, easy go?

The counterpoint, which is really just a separate problem, is that mainland money follows the circus, leaving as quickly as it came. Hong Kong shares had been undervalued for years, giving the mainland southbound investment flow a veneer of prudence.

Attracted by lower trading costs, generous margin lending, and what outside experts assumed was a desire to exploit arbitrage opportunities between Hong Kong and Chinese shares of the same company, mainland investors poured money into the Hong Kong rally throughout April, filling the Shanghai-Hong Kong Stock Connect’s quota several times.

But as Shanghai and Shenzhen shares rose to new highs, mainland money left undervalued Hong Kong to re-join the frenzy, pushing A shares and Shenzhen to even more extreme valuations. And the arbitrage opportunities? Perhaps they weren’t the reason after all. For instance, Chinese car company BYD’s (01211.HK, 002594.CN) shares were up 66 percent in the past year in Shenzhen, but just 29 percent in Hong Kong.

Mainland investors deserve some credit. While they’re known worldwide as frenzy chasers, the mainland investing culture is maturing quickly, and the Chinese penchant for saving and investing deserves to be admired worldwide as well.

Bloomberg cited a survey by China Southwestern University of Finance and Economics showing that only 5.7 percent of mainlanders opening brokerage accounts in the last three months had a university degree. The implication, which may be true, is that the participation of the least economically sophisticated members of a society in a stock rally is a clear indication of a bubble.

But if mainlanders are unsophisticated, they’re also admirably diligent: In the United States, our home country, learning that 94.3 percent of new stock investors didn’t attend college would be unthinkable: Lower-income Americans generally lack both the savings and the interest to consider investing in stocks.

But are mainlanders really investing — or are they just gambling? Browsing through mainland stock discussion boards would seem to answer this question, but again in fairness to the Chinese, their entire modern investing culture was formed recently, and in a low-trust environment dominated by corruption and sudden government intervention.

The developed-world notion of equity as a long-term ownership interest in an operating business was as ridiculously unrealistic in China for many years as the mainland tendency to see stocks as scoring chips is to us.

Many highly sophisticated mainland investors — investors whose analysis would mix respectably among professionals in Hong Kong, London or New York — are fully aware when mainland trading ignores economic fundamentals, but often choose to participate anyway. Their reasoning is that’s how money is made in China, and they’re not about to ignore it.

Hong Kongers should hope that investors don’t start regularly profiting by ignoring fundamentals in the Hong Kong market.

Of course, bubbles and short-term trading manias happen across the world, and professional investors across the world are tempted into participating in them. But mainland markets are a league above the rest in this dimension, and if Hong Kong becomes another mainland-style casino, it risks losing its special status as Asia’s financial center.

Investors seeking China’s wild risk can now get it directly in China, whereas stability-seeking institutional investors — who so far have enjoyed Hong Kong’s rally like a welcome meal while suffering its accompanying volatility like an unpleasant appetizer — might migrate to safer havens.

Are SFC regulations adequate safeguards against the new normal?

Unsophisticated investors enable unscrupulous company leaders and ineffective business models. To many analysts, Hanergy exemplifies this. On a superficial level, Hanergy operates to whatever extent it actually operates — in a high-growth industry the Chinese government is known to support. That sounds good. But beyond that, a traditionally trained analyst would have likely avoided Hanergy for any of the following reasons:

1. Most of Hanergy Thin Film’s sales are to a “related party” — Hanergy Group, its mainland parent — which then sells finished solar panels back to Hanergy. Such a double-way related-party transaction isn’t a guarantee of corruption, but could easily mask malfeasance.

2. Parent Hanergy Group had financial problems; it was unable to pay Hanergy Thin Film Power (the Hong Kong company) for some time, and was reportedly borrowing high-interest shadow loans, while chairman Li Hejun’s business entities in the British Virgin Islands were borrowing hundreds of millions of US dollars using billions of Hanergy Thin Film’s shares as collateral.

Hanergy Thin Film and its Beijing-based parent are effectively one operating company, but investors didn’t seem to be watching the parent at all.

3. Even investors not watching Hanergy parent (again, considering that 100 percent of Hanergy’s 2013 sales were to its parent, all investors should have been watching the parent) should have seen Hanergy’s financial reports, which showed that over the past five years, sales grew by 68 percent annually, whereas accounts receivable grew by 133 percent. Hanergy Thin Film was making sales that it wasn’t collecting cash for.

4. Media reports and basic research uncovered numerous other warning signs like near-empty parking lots at factories, unfinished projects, the sale of five power plants to a company partially owned by the wife of a former Hanergy director who apparently formed the company 13 days prior to the deal, the fact that thin-film solar technology has a declining, single-digit market share (currently 7 to 8 percent for all thin-film companies), and more.

Professional investors had many reasons to avoid this company, and they did: Institutional ownership was very minimal. But while the stock market itself is a great teacher, it needs a critical ingredient: information.

Hours after China’s state-run Xinhua News Agency ran a positive video on Hanergy in which Li Hejun declared that the SFC investigation into Hanergy that many people had presumed to be happening was “absolutely impossible”, the SFC issued a rare statement confirming that it had, indeed, been investigating Hanergy. The sad irony is that in Hong Kong, companies actually are forbidden from disclosing SFC investigations, and the SFC rarely discloses them itself.

Secrecy undermines trust, and Hong Kong’s credibility is too important to keep SFC investigations secret. Backdoor tricks to list shares while avoiding the scrutiny of an IPO — such as the one Hanergy used by injecting itself into an existing public shell company — should be restricted.

And to reiterate a point that Cheung Kong Graduate School of Business professor Gan Jie mentioned in a recent Forbes article, Hong Kong should open a wider door to allowing shareholder lawsuits against companies.

Mainland regulators protect investors with 10 percent price movement limits. They also ensure tighter trading with settlement occurring the day after the trade (T+1), and require all buy orders to be paid for upfront and all sellers to actually possess the shares to sell at the time the sell order is placed.

Some people may suggest that Hong Kong impose mainland-style trading limits if its stock exchange must now contend with extreme trading volatility. Such caps — especially caps as low as 10 percent — not only hide true price discovery but also risk advertising Hong Kong to the world as a market whose investors cannot be trusted to behave rationally until their emotions have cooled.

More sensible would be for Hong Kong to shift from its current T+2 trade settlement to T+1. The historical reason for delayed trade settlement was understandable: In the 1700s, messengers needed 14 days (T+14) to transport share certificates of cross-listed stocks between Amsterdam and London.

There is no reason for settlement delays in today’s internet age. Delayed settlement lowers trust and worsens volatility, especially extreme volatility. Hong Kong should learn from mainland regulators on this topic, as well as in requiring actual cash or share inventory as the trade orders are placed. All would buffer against wild price swings.

More money, more problems

In 1997, the producers of American rapper Notorious B.I.G. released one of the rapper’s previously recorded songs entitled “Mo(re) Money, Mo(re) Problems” shortly after he was shot and killed. The title became a popular American saying — a saying that fits Hong Kong perfectly now.

Mainland investment money sparked a much-needed rally, which promoted other investors to join in. Hong Kong is thankful. But it also brought unwanted volatility and mystery. Mystery adds value to movies and novels, but not to stock markets.

It’s a wake-up call for Hong Kong investors. It’s also a wake-up call for Hong Kong regulators. Mainland investment money — its coming, its going and its behavior while in Hong Kong — is a new force in Hong Kong.

Mainland money brings volatility. It brings companies that will exploit mainland money. It brings a group of investors who will be significantly more sophisticated in 10 years (or after their next bear market, whichever comes first). It brings curious foreign investment. It brings challenges for Hong Kong investors, whose long-term best interests are in avoiding frenzies, and to regulators.

But most importantly, it can bring wealth to Hong Kong — if the right choices are made.

The article first appeared in the July 2015 issue of Hong Kong Economic Journal Monthly.

James Early and Alex Pape, CFA, are CEO and Chief Investment Officer of Iwaitou.

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James Early is chief executive of Iwaitou. Alex Pape is Chief Investment Officer of the firm.

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