Stock Connect - the first three years
The Stock Connect program between the Shanghai and Hong Kong stock exchanges was first launched on 17 November 2014, with the Shanghai-Hong Kong link further extended in December 2016 to include Shenzhen-listed shares.
The Connect currently provides access to 576 Shanghai-listed stocks and 943 Shenzhen-listed stocks on the Northbound as well as to 443 Hong Kong listed stocks on the Southbound. The program includes daily quotas of RMB10.5bn (€1.35bn) and RMB13bn (€1.67bn) for Southbound and Northbound directions respectively, however the aggregate quotas, initially introduced, were later abolished.
The launch of the Connect program was a major step towards the integration of China’s onshore and offshore equity markets and the further opening of mainland capital markets. At the initial stage, the Connect program did not entirely live up to market expectations. The unsubstantiated, mainly debt driven meteoric rise of the Chinese A shares in the first half of 2015 – the Shanghai Composite index more than doubled from November 17, 2014 through June 15, 2015 – confused foreign, mostly fundamental-driven, investors. The subsequent collapse of the onshore indexes further cooled investor enthusiasm. The initial flows into the onshore market peaked in June 2015 when the Shanghai Composite index hit a seven-year high and foreign investors invested a record RMB117bn in the Shanghai-listed shares via the Connect.
However, as the ensuing market turmoil erased most of the gains, the inflows into the A shares market predictably turned into outflows in the second half of 2015. As a result of the market turmoil and RMB depreciation pressure, the launch of the Shenzhen-Hong Kong link had been feared to be delayed or even entirely cancelled but, in the end, Chinese regulators decided to stick to their commitments and launched the Shenzhen link in December 2016, thus making accessibility to the A shares market nearly complete. The addition of the Shenzhen link was a major factor behind the success of the program, as there are many “new economy” stocks and private non-financial companies popular with foreign investors that are listed in Shenzhen. Flows via Connect started to recover in 2016 as Chinese economic performance began to improve and, importantly, CSRC adopted an aggressive stance in trying to fix structural issues on the mainland equity markets.
Program a clear success
However, despite earlier challenges, the Connect program has been a clear success, in our view. The scheme has essentially integrated China onshore and offshore markets, which had operated before as distinctly different markets. Through the link, global investors were provided with an opportunity to significantly upgrade their portfolios by including a number of high quality A shares companies, especially in consumer, IT, and healthcare sectors. Importantly through Connect, foreign investors can now gain exposure to one of the most interesting parts of the Chinese market, specifically environmental and clean-tech companies that are primarily listed in the domestic market. Even more so, companies operating along each part of NEV supply chain, an area that we find particularly attractive given China’s commitment to abolish all traditional fuel vehicles, are largely accessible through the Connect.
The availability of the Connect program was one of the most important factors behind MSCI’s decision to add onshore listed stocks to its global indices, announced in June 2017. As China’s domestic shares will be gradually added to MSCI global indices starting from next June, the Connect program will undeniably gain further popularity as MSCI has officially endorsed it for accessing A shares. At the same time, mainland investors have also benefitted as they can diversify portfolios by legitimately investing in stocks listed in Hong Kong, often at much cheaper valuations compared to onshore equities.
Untapped markets offer potential
The China A shares market is the last major equity market largely untapped by global investors as foreign participation is estimated at a mere 2-3%. It is an especially interesting place for active fund managers emphasising stock picking, as the market is relatively information inefficient compared to other markets. There is significant potential to generate sizeable alpha with reasonable risk. Proprietary in-depth research, frequent company visits, patience and discipline are all essential ingredients to succeed.
With the available 3-year trading history, we can review some of the figures. Average daily turnover (defined as buy orders) was approximately RMB2.6bn and RMB2.2bn for Northbound (NB) and Southbound (SB) respectively. Net inflows averaged RMB0.3bn and RMB0.7bn for NB and SB respectively since inception of the program three years ago. Interestingly, cumulative Southbound flows have substantially exceeded those of Northbound – ca RMB500bn flowed into Hong Kong through the end of October vs RBM200bn in Shanghai-listed shares. This could be explained by cheaper valuations in the Hong Kong market, especially in the mid- and small-cap universe and the increased desire of mainland investors to diversify their financial holdings, as the Connect program is the only legitimate channel for mainland investors to invest in offshore market. At the same time, the initial expectation for erasing valuation discrepancy for dual-listed companies between the onshore and offshore markets has not materialized: the Hang Seng China AH premium index currently stands at 28%, a much higher level compared to three years ago when a premium for dual listed A shares was only 2%.
Kweichow Moutai, a well-known producer of Chinese high-end liquor, has been one of the most popular Northbound stocks and Tencent, a Hong Kong-listed China internet giant, has been well-traded on the Southbound direction. The addition of these two stocks to investors’ portfolios would significantly enhance return profile as both Moutai and Tencent gained staggering 339% and 192% (in dollars) respectively since the launch of the program in November 2014. Additionally, shares of HSBC, Chinese insurers, banks, casino operators and IT companies were especially popular with mainland investors. On the Northbound side, shares of home appliance, food and beverage and IT companies were in high demand by foreign investors.
International investors, while being skeptical at the initial stage, have gradually accepted the Connect program, as Chinese and Hong Kong regulators introduced a number of improvements to the program along the way, including an abolishment of the aggregate quotas. The brisk southbound trading was an important contributor to MSCI China’s 50%+ gains this year, making it one of the best performing markets globally. Leveraging on the success of the Connect program, the PBOC and the HKMA launched a mutual access scheme between the mainland and Hong Kong bond markets, the so-called “Bond Connect”. Even though, the program only works in the Northbound direction at this stage, it is nevertheless another major step in capital market opening and RMB internationalisation and is in line with China’s commitments to gradually reform and further open its financial markets.
Dmitriy Vlasov is portfolio manager at East Capital
