Quotas on the Shanghai-Hong Kong Stock Connect are set to rise sharply as part of China’s push to qualify its domestic stocks for inclusion in the widely-tracked MSCI Emerging Market Index, say market participants.
An announcement could come as early as today if regulators and stock exchange officials in mainland China and Hong Kong agree they want to be seen making necessary reforms in advance of MSCI's deadline. Sources tell FinanceAsia that an announcement regarding quotas and other factors is ready pending final approvals.
The Hong Kong and Shanghai stock exchanges may also combine a quota increase with announcements for a futures contract for China A-shares tradable in Hong Kong plus a widely anticipated link to Shenzhen’s stock market, one of the market participants said: “They could announce the trifecta.”
Other market players say these developments will come but perhaps staggered over coming months, assuming MSCI delays immediate inclusion but paves the way for an accelerated process that does not depend on waiting for another annual review.
Index compiler MSCI is due to decide on June 9 in the US whether to include mainland Chinese equities, known as A-shares, in its emerging market benchmark indices as part of its annual market reclassification, a move that could attract tens of billions of dollars into mainland stocks.
One of the reasons MSCI has been reluctant to include A-shares to date is that China’s stock markets are still not freely tradable by foreign investors, as illustrated by the quota system on the Stock Connect pilot scheme launched last November, according to MSCI’s review last year.
To assuage such concerns, regulators in mainland China and Hong Kong agreed on nearly doubling the northbound daily quota on Stock Connect, from Rmb13 billion ($2.1 billion) to Rmb20 billion ($3.2 billion), according to one market participant. The aggregate northbound quota of Rmb300 billion ($49 billion), which has particularly worried passive index trackers, is also set to rise and may even be abolished.
Hong Kong Stock Exchange chief executive Charles Li told a conference on May 20 that the quotas would rise very soon, but he gave no details.
Full inclusion in MSCI Emerging Market index would lead to passive inflows of at least $47 billion, according to an estimate by HSBC.
Few market participants expect that the MSCI will announce it will include A-shares in its benchmarks next week, but one suggested that it may start due diligence, meaning it would not need to wait a full year before revisiting the matter. If so this suggests inclusion may be a matter of months – which is why the stock exchanges and securities regulators need to act promptly to boost two-way capital flows.
With caps on trading volumes in place, passive index trackers worry that the quota may fill when they are mid-trade, leaving them unable to track the index accuarately.
Brokers have rushed to reassure funds that they will complete trades on funds’ behalf using their own inventory – generating their own counterparty risks – but most money managers are still reluctant to expose themselves to a potential breach of their mandates.
Other snafus that have delayed long-only participation in Stock Connect and A-share inclusion in MSCI indices have been confusion over beneficial ownership and taxation.
“Concerns around capital mobility, clearing and settlement, and taxation persist. These are seen as making the A-share investment proposition inflexible and restrictive for index fund managers,” said Vijay Sumon, an analyst at HSBC in a research note to investors dated June 4.
Regulators and the exchanges have been working hard to set these points right. They have also come to an understanding with authorities in Luxembourg, the domicile of many Ucits mutual funds (which must adhere to certain rules to qualify for marketing throughout Europe) and are close to agreement with regulators in Dublin, the other main domicile for Ucits funds. Getting Ucits managers qualified to invest in Stock Connect is key to attracting more long-only flows, as most northbound activity to date has been conducted by hedge funds.
The Hong Kong bourse also announced in May a way for funds to limit execution risk by spreading trades beyond just one broker with custody arrangements via use of special segregated accounts (SPSA).
Future role for Hong Kong
Hong Kong is keen to have a futures contract based on the CSI 300 Index to trade on its exchange.
This would be similar to Singapore’s SGX FTSE China A50 Index Futures contract, which offers exposure to mainland China’s stocks and has risen in popularity over recent months by funds hedging long positions on mainland China stocks. The A50 index has doubled to 13,787 points over the past year.
For securities regulators, having a tradeable hedging tool in Hong Kong would enable better risk management – although hedge funds may well use it to leverage bets as well as hedge them.
But the biggest development to come will be creating a similar scheme to Shanghai-Hong Kong Stock Connect between the Shenzhen Stock Exchange and Hong Kong, to be launched in the second half of this year. Although this will initially be a separate programme, the legal and market infrastructure is similar so a launch should be straightforward.
“The next key milestone [in the evolution of China’s capital markets] will be the development of the Shenzhen-Hong Kong Stock Connect, which we expect to happen in the second half,” said Damien Horth, head of equity research, Asia Pacific UBS on a recent conference call.
Additional reporting by Jame DiBiasio
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