This big thing happened in China last week – but you probably didn’t hear about it

As of December 5, foreign investors have access to China’s version of the Nasdaq. It’s an important step in the continued liberalisation of China’s markets.

This is the second mainland-Hong Kong connect, following the launch of the Shanghai-Hong Kong Stock Connect in 2014.

But you probably didn’t hear much about it. That’s partly because there hasn’t been a flood of foreign money pouring into the Shenzhen market since the launch.

And there won’t be, until one big change to global indexes is made.

These stock connects – which are in essence a way to connect exchanges – allow foreign investors to invest in mainland China-listed A-shares via Hong Kong.

The Shanghai and Shenzhen stock connects combined give non-Chinese investors access to about 80 percent of the combined Chinese markets.

Previously, a limited number of large foreign institutional investors had to pre-qualify with the Chinese government to own Shanghai or Shenzhen-listed shares.

This is known as the Qualified Foreign Institutional Investor Scheme (QFII).

The three connected exchanges (Hong Kong, Shenzhen, Shanghai) make up the second-largest equity market in the world, after the New York Stock Exchange (NYSE).

Source: Truewealth Publishing Asia

 

Differences between Shenzhen and Shanghai

Think of the Shenzhen market as the U.S.-based, tech-heavy Nasdaq, and the Shanghai Exchange as the old-school Dow Jones Industrial Average.

The Shenzhen Stock Exchange has 1,800 listed companies. Five hundred of those are in “new economy” sectors, like information technology, renewable energy and biotech.

It’s viewed as the gateway to some of China’s most exciting and fastest-growing companies. And about 75 percent of those companies are privately run, rather than state-owned.

But Shenzhen is still in manufacturing-dependent China, so about one-third of the companies listed (by share of market capitalisation) are involved in manufacturing.

Source: Truewealth Publishing Asia

Shenzhen is also one of the busiest stock exchanges in the world. In July 2016 , about US$1.20 trillion worth of securities were traded in Shenzhen.

That was close behind the US$1.27 trillion traded on the New York Stock Exchange (NYSE) in July. And it was more than the US$713 billion traded on the Shanghai Exchange.

The Shanghai Stock Exchange is home to more industrial and staid “old economy” companies.

Many of the 1,100 listed companies are China’s large, state-owned-enterprises. It’s dominated by financial, manufacturing and utility companies.

Source: Truewealth Publishing Asia

Shanghai was overtaken by Shenzhen earlier this year as the Chinese exchange with the highest daily turnover.

This could partly be due to domestic Chinese investors looking for better growth opportunities in the smaller companies listed on the Shenzhen exchange, especially after the Chinese market meltdown in the summer of 2015.

Shanghai was overtaken by Shenzhen earlier this year as the Chinese exchange with the highest daily turnover.

This could partly be due to domestic Chinese investors looking for better growth opportunities in the smaller companies listed on the Shenzhen exchange, especially after the Chinese market meltdown in the summer of 2015.

 

How the Shanghai-Hong Kong Stock Connect has fared

Despite the excitement surrounding the Shenzhen Exchange, the launch of the Shenzhen-Hong Kong connect on Monday was met with a quiet sigh by investors.

Only one-fifth of the daily quota for the new connect was traded on launch day.

But this shouldn’t have come as a surprise. The existing Shanghai-Hong Kong Stock Connect got a lot of people excited when it launched two years ago, too.

But it has fallen short of (very high) expectations as well.

For both stock connects, there is a daily quota, or limit, on how much money can flow north or south on a daily basis.

The southbound total refers to how much mainland investors can trade in the Hong Kong market. The northbound quota limits how much Hong Kong-based investors can trade on a mainland exchange.

For the Shanghai-Hong Kong Stock Connect, the southbound daily aggregate (that is, the amount of money flowing from China to Hong Kong) of US$1.5 billion has been used up only once.

And the northbound aggregate (money moving from Hong Kong to China) has never been used up.

In fact, only about half of the northbound quota is used daily. Last summer, when the Shanghai Composite was peaking, about US$917 million per day was flowing from Hong Kong into the Shanghai market.

But the 30-day northbound average is now just one-quarter of that.

This, and the low trading volumes for the new Shenzhen-Hong Kong connect so far, shows foreign investor interest in China’s A-share market is lukewarm at the moment.

But 82 percent of the southbound quota is used each day, on average. This means that even though the Shanghai-Hong Kong Stock Connect was set up to allow more foreign investment in mainland China markets, it’s been the domestic Chinese investors taking advantage of it to get money out of China.

This has especially been the case as the renminbi’s value versus other currencies, especially the U.S. dollar, has been falling.

 

What could change everything

The Chinese Communist Party has its reasons for setting up stock connects. One of them may be in part to satisfy the MSCI Emerging Markets Index inclusion committee.

As we’ve explained before, the world’s largest, most influential emerging markets index, from MSCI, does not include mainland China-listed A-shares.

Over one trillion dollars’ worth of investment funds and ETFs use the MSCI Emerging Markets Index as a benchmark. This means that they pretty much copy the components of this index.

So if the index makes a change by adding or removing a company from the index, a huge volume of shares in that company changes hands as various investment funds match the index’s move.

The MSCI Emerging Markets Index includes China, but it uses Chinese companies listed on the Hong Kong Exchange for its China exposure.

The reason it doesn’t use A-shares, or shares of companies listed on mainland exchanges, is because many big investors are worried about putting too much money in mainland China stock markets – especially after the Chinese government manhandled Chinese markets during the summer of 2015’s market collapse.

Another big concern is whether investors would be able to get their money out if there was another stock market crisis.

 

What index inclusion would mean

That China developed and launched the Shanghai and Shenzhen stock connects sends a signal that it wants to make it easier for large foreign investors to buy and sell China A-shares.

If MSCI, and the big investors it consults with, see other positive moves by Chinese regulators to open China’s markets, it’s only a matter of time before the emerging markets index starts including mainland-listed A-shares.

When it does, then expect to see the daily volume of shares trading hands between Shanghai, Shenzhen and Hong Kong increase.

That’s because billions of dollars of new foreign money will suddenly be interested in A-shares – and will use the stock connects to buy and sell them.

When that happens, expect the A-share premium to Hong Kong-listed H-shares to fall. (We discussed that pricing anomaly here.)

Investors looking for exposure to China’s A-shares have a few options via ETFs. A very popular one that trades on the Hong Kong exchange is the iShares FTSE A50 China Index (Hong Kong; code: 2823).

This tracks the performance of fifty of the largest Chinese companies that trade on the Shanghai or Shenzhen exchanges. The ETF doesn’t own the shares, but it uses derivatives to mimic how those shares perform.

Singapore has the United SSE50 China ETF (Singapore; code: JK8), which also tracks 50 of the largest China A-shares. The trading volume for it is quite low, so be careful when you buy and sell it.

If you would like to buy China A-shares in the U.S., your options are limited. There are a few small ETFs that track A-shares, like the iShares MSCI China A ETF (BATS Exchange; ticker: CNYA), or the CSOP FTSE China A50 ETF (NYSE; ticker: AFTY). But these have low trading volumes too, so careful trading them.

We’ve put together a free report to help investors access China’s stock markets… it’s available here. And part of our recently launched research service involves investing in China’s markets… for more on that, click here (and click “Subscribe Now” at the bottom of the screen to read the text, rather than listen to my voice!).

Visit Truewealth Publishing Asia's website at https://truewealthpublishing.asia.

(By Kim Iskyan)

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