What Will the SH-HK Stock Connect Bring?

By+XIANG+ANBO+&+ZHOU+QIAN

THE Shanghai-Hong Kong Stock Connect Program is a strategic decision the Chinese government has taken to meet the needs of equity markets on the mainland and in Hong Kong Special Administrative Region. It represents an institutional innovation in the countrys capital market.

During the first 25 trading days after the launch of the program on November 17， 2014， more than RMB 71 billion flowed into the mainlands A-share market and RMB 9.5-plus billion into the Hong Kong market via the Stock Connect. Although the trade volume did not show explosive growth， it remained stable and orderly. It will take time for investors to warm to this scheme. In the long term， however， the Shanghai-Hong Kong Stock Connect will create the worlds second largest open equity market， and deepen integration of Chinas and the global capital market.

Connectivity and Two-way Opening

The program marks a breakthrough as regards the mutual opening of stock markets on Chinas mainland and in Hong Kong； it promotes their connectivity and expands common investment channels. The scheme also facilitates， and thus draws overseas investments in the Ashare market， and enables mainland investors to deal on the Hong Kong stock market. This broadens the investment portfolio and hence improves both sides market structure， contributing to their common prosperity. The Shanghai-Hong Kong Connect also gives international investors more choices.

The scheme has huge impact on the mainland stock market because it widens the conduit through which outside capital can enter the A-share market. The ShanghaiHong Kong Stock Connect will divert an estimated additional US $22 trillion of Chinese bank assets into the capital market， of which close to US $8 trillion is expected to be earmarked for A-shares. The size of the market will hence likely double in the coming five to 10 years. The program also makes more likely the inclusion of Ashares in the MSCI World Index – a prospect that could attract US $12-170 billion more overseas capital into the A-share market.

The Shanghai-Hong Kong Stock Connect enables a two-way capital flow between bourses on the two destinations. It can therefore improve the A-share market by maintaining a rational system of valuation. It also improves the composition of A-share investors， and entrenches in Chinese investors the principle of value investment.

The program gives the Shanghai Stock Exchange access to 268 blue chips in Hong Kong and about two million investors in the region， many of whom are worldclass institutional investors. By welcoming mature foreign institutional investors and capital it optimizes the A-share investor structure.endprint

The Shanghai-Hong Kong Stock Connect program diversifies mainland investors asset allocations and gives them access to the international capital market. It also opens Hong Kong Exchanges and Clearing Limited stocks to mainland institutional investors and individuals with more than RMB 500，000 in their securities and cash accounts. They may thus participate in mature capital markets and have more asset allocation alternatives. Medium-sized and small investors looking to optimize their investment portfolios are well advised to venture into the international market via that in Hong Kong.

The Stock Connect is a bonus for the mainland A-share market because it promotes internationalization and marketization of A-shares over the long term. By opening the A-share market to Hong Kong investors it， in effect， becomes open to capital from all over the world.

The main benefit of the Stock Connect to Hong Kong is that of its generating a sustained inflow of capital. International investors can enter the mainland equity market through this program， and mainland investors can likewise use Hong Kong as a springboard to enter the international capital market.

Further Opening of Chinas Capital Market

The Shanghai-Hong Kong Stock Connect will encourage Chinas securities market to adopt international trade rules and investment conceptions. This will enhance its internationalization and opening-up.

Supervisory bodies in Shanghai and Hong Kong have designed a package of solutions that will clear divergences between the two cities with regard to laws， market structure， and trade rules. It positions the two stock ex-changes， with the clearing houses behind them， as counterparties that absorb as many market divergences as possible before adapting to the remaining “unchangeable”factors.

The stock exchanges and clearing houses behind them in Shanghai and Hong Kong are ostensibly the sole crossborder investors under the new scheme. But tens of thousands of investors actually trade shares in the two locales and beyond. As regards differences in trading rules， the Stock Connect does not set any price limit， and is more subject to swings in the U.S. and European markets and prices of bulk commodities. It follows the same day （T+0） trading pattern instead of the trade date plus one day（T+1） that the Shanghai Stock Exchange has operated for the past 20 years. All of this imposes higher demands and poses grimmer challenges to mainland investors. But as in the course of all this they learn about and become acclimatized to international rules， the mainland equity market will thus gradually mature.endprint

Second， the Shanghai-Hong Kong Stock Connect constitutes a breakthrough with respect to the ensuing opening-up of the capital market and capital account on Chinas mainland. Previously， cross-border investment in the mainland equity market was only possible under certain projects， including that of the Qualified Foreign Institutional Investor （QFII）， whose quota is US $56.5 billion， and the Renminbi Qualified Foreign Institutional Investor （RQFII）， whose quota is RMB 250 billion. At present the Stock Connect allows a maximum cross-border investment of RMB 550 billion （US $90 billion） – almost 50 percent more. Free of the capital lock period， the new scheme is more flexible than the QFII and RQFII. It also means lower costs and fewer risks for investors.

In addition， the Stock Connect entails cross-border investment settlements under the capital account， rather than bilateral commodity trade settlements under the trading account. This expands the scope of RMB convertibility under the capital account. It also opens new investment channels for cross-border RMB investment， expanding the scope and range of the flow and cross-border use of the Chinese currency.

Third， the Stock Connect boosts RMB internationalization by facilitating mainland investors direct RMB investment in the Hong Kong market. It meanwhile opens up new RMB investment opportunities outside of Chinese territory. This results in orderly circulation of the Chinese currency between Chinas mainland and Hong Kong， upgrading it from a trade settlement currency to an investment currency of solid standing. It moreover lays the groundwork for the RMBs use as a reserve currency. In short， the Stock Connect plays a positive role in propelling the evolution of the RMB into a dominant international currency， and in expanding and improving the RMB assets portfolio.

Finally， the program provides a new test platform for reforms to Chinas capital market and financial system as a whole. The success or failure of this platform will have considerable bearing on deepening reforms to Chinas capital market， RMB internationalization， the role of Hong Kong as an offshore RMB business center， and the degree of cross-border capital flows and convertibility in financial transactions.

Investment Opportunities

The Stock Connect has drawn international capital from North America， Europe and the Middle East， evident in the first half of 2014 from the surging capital flow into Hong Kong. The program is acknowledged as offering enormous opportunities to institutional and individual foreign investors for the following reasons.endprint

First， enabling foreign investors to directly trade Ashares upon opening an account in Hong Kong makes this the most liberal scheme the Chinese government has ever devised for foreign investors participation in the mainland equity market. They were previously obliged to negotiate layers of approval procedures， and also faced quota restrictions.

Second， the Stock Connect exempts foreign buyers from capital gains tax on purchases of mainland stocks， so reducing their investment costs.

Third， the participation of foreign investors in the mainland capital market is so far low （less than two percent of shareholders listed on the Shanghai Stock Exchange are from outside of the country）. This， on the one hand， highlights the fact that the capital market on Chinas mainland is far from mature. But on the other it implies huge growth potential and unexplored investment terrain in the worlds largest emerging economy， which also houses the worlds second largest stock market.

International investors， however， are advised to appropriately control risks， to accustom themselves to different trading hours and supervisory rules， and to the ShanghaiHong Kong Stock Connect settlement system.endprint