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WorldJune 2 2014

Shanghai-Hong Kong Stock Connect: a mutually beneficial arrangement

The Shanghai-Hong Kong Stock Connect will foster stock trading and capital flows between Hong Kong and mainland China, with numerous potential benefits for both sides. But competitors in the Asia-Pacific region are concerned it might eat into their market share. 
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Shanghai-Hong Kong Stock Connect: a mutually beneficial arrangement

The Shanghai-Hong Kong Stock Connect created a strong air of excitement in the Asian markets and beyond when it was announced in April. Once launched, the initiative will connect the Stock Exchange of Hong Kong with the Shanghai Stock Exchange, allowing mutual market access in designated equities, considerably enhancing the financial links between the former UK colony and the Chinese mainland.

The connect opens a path to the Shanghai Stock Exchange for all Hong Kong and overseas investors, but only institutional investors and those with an aggregate balance of Rmb500,000 ($81,000) or more in their securities and cash accounts will be allowed to trade from the mainland side of the system into Hong Kong. The potential benefits of the connect are numerous for both sides and many in the markets are looking forward to the implementation of the system with serious enthusiasm.

Growth potential

“The Shanghai-Hong Kong Stock Connect provides each exchange with a new menu of equity products to offer investors, plus a potentially large new customer base,” says Nick Ronalds, managing director and head of equities at the Asia Securities Industry and Financial Markets Association (Asifma).

Mr Ronalds adds: “Hong Kong brokers will be able to offer clients stocks traded on the Shanghai Stock Exchange, and Chinese brokers will be able to offer stocks traded on the Stock Exchange of Hong Kong. The potential growth in business for the exchanges and their members is considerable.”

According to Mr Ronalds, the availability of many more Chinese stocks provides a channel for better diversification for non-Chinese investors. “More diversification means lower risk, all else being equal, and a greater willingness to hold stocks in general. Also, the Chinese stocks accessible through the link will open up spread strategies between Chinese and non-Chinese stocks, which would increase trading volume rather than shifting it from one location to another,” he says.

The economic benefits are clear, but the tie-up also represents a strong political willingness on the part of the Chinese government to open up mainland markets to outside investors. Reluctance from China to do this in the past often frustrated investors who were keen to raise their exposure to Chinese assets through quicker and easier methods such as stock trading.

Carrying out trading from Hong Kong will increase investor confidence when considering issues such as dispute resolution that arise as a result of market activity. This further integration of Hong Kong and its world-class financial centre with the mainland sends a strong signal about China’s global outlook.

Regional competition

The Shanghai-Hong Kong Stock Connect will provide strong benefits to certain market participants, but there may be slightly less enthusiasm from competitor exchanges elsewhere in the Asia-Pacific region. There are a number of strong regional exchanges that compete with Hong Kong and Shanghai for trading volumes, which boost liquidity in their respective bourses. According to the chief executive of one stock exchange outside the region, exchanges elsewhere in Asia-Pacific would likely be looking at the potential competitive impact rather than the benefits.

“Other exchanges won’t be too happy as it might eat into their market share,” says the source. “The Japanese market has always been relatively closed; it doesn't compete as intensely as the others. Singapore, Australia and Korea could be concerned about market share.”

The source adds that an arrangement such as the Shanghai-Hong Kong Stock Connect is something that is always a possibility for smaller exchanges, but it is an unusual move for two large venues such as the Shanghai and Hong Kong stock exchanges. “This is quite a special case because the two exchanges have big markets between them. For the big organisations, unless they create something based on capital, the rationale is not that obvious.”

No threat?

Whereas rival exchanges are no doubt watching closely how the connect develops and what impact it may have on their businesses when it is up and running, there are those who believe the competitive dangers from the new system could be overestimated and that it is better seen as a local initiative that affects only the two exchanges involved.

“I’m not sure it should affect the other exchanges too much as the link is to ease cross-border trading in Chinese equities,” says a legal source working in Asian capital markets. “I’m not sure the other exchanges should see it as a threat. What it’s underlining is the closeness of the Hong Kong and Chinese markets. Hong Kong positions itself as the gateway into China, so this is a continuation of that.”

The legal source also believes that the connection may lead to more co-operation down the line. “I would expect this to be the first in a series of further steps,” he says. “This is less to do with promoting the business of either [bourse] and more to do with loosening capital controls. I would expect there to be many more steps opening up investment.”

This view is backed up by Mr Ronalds at Asifma, who believes continued co-operation seems highly likely due to the mutual benefits involved. “The Hong Kong exchange is attractive to the Chinese side because it has experience with a wide range of products, such as options and warrants; and Hong Kong's history as a financial centre has created a deep pool of talent experienced in international markets.

“For offshore investors, Hong Kong's regulatory and legal environment makes it an attractive conduit to Chinese stocks. From the Hong Kong perspective, the Shanghai exchange represents a widening of the product menu and access to a large pool of new clients. The synergies all around are evident.”

Launch date

According to the website of Hong Kong Exchanges and Clearing (HKEx), the parent company of the Stock Exchange of Hong Kong, the launch of the project can only take place once certain regulatory approvals are in place, the relevant trading and clearing rules and system have been finalised, and market participants are given enough time to adapt their systems. Therefore, the preparation for the formal launch of the project is expected to take about six months to complete.

There are strict rules about what can be traded back and forth along the connect. With northbound trading going from Hong Kong to Shanghai, only so-called ‘A’ shares denominated in renminbi will be initially included in the scheme. Products such as ‘B’ shares denominated in foreign currency and assets such as exchange-traded funds, bonds and other securities will not be included, according to HKEx.

Coming southbound, mainland investors will be limited to trading the constituent stocks of the Hang Seng Composite LargeCap Index and Hang Seng Composite MidCap Index and all 'H' shares not included as constituent stocks of the relevant indices but which have corresponding shares in the form of Shanghai-listed shares, with some exceptions, says HKEx. There will initially also be both an aggregate and daily quota attached to trading activity under the system.

The Stock Connect has certainly been well received by the investment communities of both the Chinese mainland and Hong Kong. The long-awaited initiative solidifies the ties between the two markets and offers the prospect of more co-operation in future. How it will affect rival exchanges in the Asia-Pacific region remains to be seen, but they will certainly be watching closely as the finer details of the project emerge.

“We believe that this development will pave the way for the further opening up of mainland China's capital markets and help promote the internationalisation of renminbi,” says HKEx chief executive Charles Li. “We also believe this development will provide a new opportunity and create momentum for the further development of the Hong Kong capital market. We will continue discussions with our mainland counterparts and make a further announcement to update investors and the market in due course.”

China’s hunger to connect its capital markets with the outside world through the Shanghai-Hong Kong Stock Connect has been warmly welcomed from those outside who see it as a long overdue innovation. And depending on the success of the project when it comes online, this could be just the start of a wider embrace of the global financial system from the Chinese government, providing the initial stages of the project prove a success.

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