On Monday, the Shanghai-Hong Kong Stock Connect is set to officially launch, after months of anticipation. The scheme aims to link up the stock exchanges of Hong Kong (HKSE) and Shanghai (SSE), allowing investors in either exchange to trade on both stock markets.
On the Southbound link, institutional investors and individuals with over RMB 500,000 in their brokerage accounts may trade Hong Kong shares through a broker on the Shanghai stock market; while heading Northbound, Hong Kong investors and international investors with Hong Kong brokerage accounts may trade shares listed on the SSE. Note: there are no limitations on the type of investor or net worth on the Northbound link.
Both channels will use the RMB for transactions. Northbound investors will use offshore RMB deposits to trade on the Shanghai exchange; Southbound investors will trade on the Hong Kong Stock Exchange using Hong Kong dollars, like all other participants, but clearing will take place in RMB. Southbound investors trading on the Hong Kong exchange will have to convert their RMB into Hong Kong dollars when entering the market, and convert them back into RMB when exiting a position.
Not all shares will be eligible to be traded under the scheme. On the Shanghai Stock Exchange, Northbound investors are limited to purchasing A-shares listed on the SSE 180 and SSE 380 Indices. On the Hong Kong Stock Exchange, Mainland investors may trade shares listed in the Hang Seng Large Cap and Mid Cap Indices.
Investors on both sides may also trade shares of companies that are listed on both the SSE and HKSE, as A-shares and H-shares respectively. A-shares refer to RMB-denominated shares on Mainland stock exchanges and H-shares to RMB-denominated shares in Chinese companies traded on the HKSE.
This has led to an interesting situation where shares in the same company now trade at different prices in Hong Kong and Shanghai, a phenomenon tracked by the Hang Seng China AH Premium Index. With these shares now available to both SSE and HKSE participants, this difference should erode. There is, however, a ban on all types of short selling in the Northbound link (HKSE participants trading on the SSE), so consolidation would likely see a rise in H-shares, rather than a tumble in Shanghai A-shares.
Apart from the types of shares, the pilot scheme comes with limitations on the total RMB value of shares that can be traded through the exchanges. For the Northbound link, there is an aggregate cap of RMB 300 bn and RMB 13 bn daily. Southbound trading, meanwhile, will be limited to RMB 250 bn aggregate and RMB 10.5 bn daily.
To gain a better understanding of these new developments, China Briefing spoke with Terrill Frantz PhD., a professor at Peking University HSBC Business School. While much has been made of the possibility of A-share/H-share arbitrage following the launch of the pilot Connect, Prof. Frantz believes this opportunity may be short-lived.
In his mind, a much more interesting dynamic will come from the daily caps on the RMB value of trading. Prof. Frantz foresees real time tracking of the daily trade volume by regulators, but noted uncertainty of what will happen when the volume reaches its daily limit – e.g., will trading be halted ? This could mean the price of a particular popular stock soaring in a short amount of time as trading approaches the quota.
Prof. Frantz likened it to trading a German company while in New York, where the company files an earnings report at the end of the day. New York traders can take full advantage of the new information, whereas German investors must wait for the market to open the next day. Based on the daily quotas in the Shanghai-Hong Kong Connect scheme, this could happen during the day, on a daily basis.
Impact on QFII program
Previously, the only way for foreign investors to trade A-shares was through the Qualified Foreign Institutional Investors (QFII) program. This was one of the first efforts to internationalize the RMB. Under the program, a small number of foreign financial institutions are allowed to invest in the RMB-denominated securities market in China, including A-shares on the Shanghai and Shenzhen stock exchanges, but also bonds and futures.
These financial institutions can then sell financial products based on their investments in China. Investments through this channel are still subject to capital controls, with quotas allocated to individual entities. Over the past several years, these quota allocations have played a role in Chinese diplomacy, such as a RMB 80 billion quota granted to French investors during Chinese President Xi Jinping’s European tour earlier this year.
In Prof. Frantz’s view, the impact of the Shanghai-Hong Kong Connect will be to annul the QFII program’s current monopoly on A-shares. He believes the biggest beneficiaries of this development will be individual investors – who in the Northbound link are now allowed to invest directly in the SSE – as well as Mainland investors who will now be legally able to trade on the Hong Kong markets.
But overall, he does not expect the new liberalization to have too great an effect on the market: “The hedge funds and individuals who are able to invest large enough amounts to matter already have access to these shares. The major players have long found ways around the limitations, regardless of whether they were allowed to.”
RMB exchange limits lifted for Hong Kong residents
In preparation for the launch of the Connect, the Hong Kong Monetary Authority (HKMA) announced the abolition of all previous restrictions on Hong Kong residents exchanging RMB to and from other currencies, also effective 17 November. Previously, Hong Kongers could only exchange up to RMB 20,000 a day. Had the restrictions not been lifted, Hong Kong investors would have hardly been able to participate in the new trading channel.
Because Hong Kong banks draw their RMB from the offshore pool in Hong Kong – also referred to as CNH – the move will not affect the flow of RMB from China into Hong Kong. This is also why the daily limit of RMB 80,000 on remittances to China shall remain in place. The new move therefore widens the range of options for offshore RMB, but otherwise does not loosen access to the China-side currency.
Overall, a great deal of uncertainty still surrounds the Connect program, despite its pending launch. It is unclear, for example, whether China will charge a capital gains tax (CGT) on the sale of shares, which Hong Kong does levy. Furthermore, under the QFII program, the Chinese authorities have not always collected CGT in the past, which adds to the confusion.
Neither does the Hong Kong-China Double Taxation Agreement touch upon the issue. Levying CGT on Northbound traders would require Hong Kong brokerages to withhold tax on their clients, something they have no experience with – the China Securities Regulatory Commission, for its part, has not given a definitive answer on the question.
Terrill L. Frantz is a Professor of Management at Peking University HSBC Business School, in Shenzhen, China. His research is focused on cross-border mergers and acquisitions, particularly post-merger integration dynamics. He can be contacted at firstname.lastname@example.org.
Asia Briefing Ltd. is a subsidiary of Dezan Shira & Associates. Dezan Shira is a specialist foreign direct investment practice, providing corporate establishment, business advisory, tax advisory and compliance, accounting, payroll, due diligence and financial review services to multinationals investing in China, Hong Kong, India, Vietnam, Singapore and the rest of ASEAN. For further information, please email email@example.com or visit www.dezshira.com.
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