China’s stock markets recorded a new milestone on Monday with the launch of a trading link between Hong Kong and Shenzhen – an initiative that leaves the mainland equity market fully open and offers a gateway to invest in some of China’s fastest-growing industries.
But enthusiasm for the link between the Hong Kong and Shenzhen bourses, home to about 1,700 and 1,800 companies respectively, is notably cooler than for the tie-up between Hong Kong and Shanghai two years ago.
In fact, stock indices in Hong Kong and Shenzhen fell 0.4% and 1.2% respectively on launch day, having been largely flat since the programme was announced in mid-August.
One key reason for the flat response was the failure of the Shanghai-Hong Kong link to live up to market expectations. The Rmb10.5 billion ($1.5 billion) southbound aggregate daily quota was used up just once. The northbound quota has never been fully utilised.
But experts still see reasons for optimism. That's because Shenzhen offers investors access to a pool of dynamic, up-and-coming companies that are fundamentally different to the more staid stocks found in Shanghai.
“If you want to invest in China’s new economy you will have to invest in Shenzhen,” said Nicole Yuen, Credit Suisse’s Greater China vice-chairman and head of equities.
Access to China's new economy
Based in a city dubbed China's Silicon Valley, the Shenzhen exchange is home to more than 500 companies in high-growth industries such as information technology, renewable energy, advanced materials and biotechnology. High-profile names include Focus Media, China’s largest outdoor advertisement company, and S.F. Express, the country’s biggest logistics firm.
In Shanghai, home to many of China's sprawling state-owned enterprises, enthusiasm from international investors has been tempered as the world's second-largest economy slows. Most Shanghai-listed companies operate in old industrial sectors such as manufacturing, resources and mining, which have declined as costs grow and the Beijing government steers the country towards a consumer-led economy.
The bright, innovative start-ups of Shenzhen, by contrast, seem tailored to the next stage of economic growth as they pour money into research and development.
More importantly, about 75% of Shenzhen-listed companies are privately run – meaning the scheme represents an important step in China's opening up of its private sector. For investors, that means an alternative investment channel to debt-laden and bureaucratic SOEs.
Steven Sun, HSBC’s head of China equity strategy, described Shenzhen stocks as the largest untapped investment opportunity in the world, adding that it was less likely to be affected by global market volatility because of its lower correlation to global equities than Hong Kong and Shanghai.
While total market capitalisation of Shenzhen stocks – at $3.3 trillion – is about 15% smaller than Shanghai's, it is more active in terms of trading activities with a daily average turnover of $60 billion. That makes it one of the most liquid stock markets in the world.
In addition, while the capitalisation is smaller, Shenzhen with its nimble start-ups offers far more tradable stocks than SOE-dominated Shanghai.
Under the stock connect, Hong Kong investors can trade 881 Shenzhen stocks – equivalent to about 71% of the exchange’s total market capitalisation – and Shenzhen investors can trade 417 Hong Kong stocks. That is about 50% larger than the Shanghai-Hong Kong scheme, under which investors were allowed to trade 568 Shanghai stocks and 268 Hong Kong stocks when the plan started in 2014.
While the Shenzhen-Hong Kong stock connect caters largely to retail investors, institutional investors also see it as a convenient way to invest in mainland equities, said Credit Suisse’s Yuen.
The scheme offers an alternative to the Qualified Foreign Institutional Investor (QFII) programme, under which eligible asset managers, insurance companies and securities firms outside China can trade Shanghai and Shenzhen stocks.
Yuen expects some offshore institutions to switch to stock connect so they will no longer be constrained by investment quotas under QFII.
It also offers higher flexibility for fund managers in terms of capital management. Under QFII, an institutional investor must deploy their capital in their custodian banks before buying A-shares, and can repatriate a maximum of 20% of total assets under management as of the end of the previous year.
In addition, stock connect remains the only investment channel for hedge funds, which are not eligible under the QFII program.
But as with the Shanghai link, the Shenzhen scheme is unlikely to fully replace QFII because it has limitations of its own, according to Yuen.
One such limitation is that the scheme only operates when both markets are open for trading. That arrangement means foreign investors will not be able to trade Shenzhen shares when Hong Kong is closed, even when it is a normal business day in China.
Yuen said many pension funds and asset managers would be obliged to invest through the QFII route since corporate law in the jurisdiction where they are registered requires them to hold shares under their own accounts.
All Shenzhen-listed shares bought through stock connect will be registered as share ownership under the Hong Kong Securities Clearing Company (HKSCC).
“Some asset managers may prefer QFII since they can show their fund holders what they have bought with their names seen on the share registry,” Yuen said. “They will not be able to do so if they take on the stock connect route.”
The tie-up between Hong Kong and Shenzhen stocks is seen as a catalyst for the inclusion of mainland shares into MSCI’s emerging market index next year, a long-awaited move which could potentially see billions of dollars surge into the country’s equities market.
“Without MSCI Inclusion, there will not be any sustained interest in A-shares,” said Yuen, noting the inclusion would provide fundamental reasons for passive fund managers to buy mainland stocks.
HSBC’s Sun said the new stock connect would widen foreign investor access to cover about 80% of the combined market capitalisation of the Shanghai and Shenzhen exchanges, potentially easing MSCI's concerns over accessibility and capital mobility in the A-share market.
With two stock connect schemes in place, the three exchanges are inter-connected and together form the second largest equity market by market capitalisation.
As such, it may only be a matter of time before the mainland market is recognised as a key components of a global equity index.