Investors hesitate before Shanghai-HK stock link

The Shanghai Composite Index closed up 2.4 percent at 2,177.95 points on Monday, its highest finish since Dec 13. Meanwhile, the clock is ticking toward October, when the Hong Kong-Shanghai Stock Connect, commonly known as the through train, is scheduled to launch. XIE ZHENGYI/CHINA DAILY

Two months away from the scheduled Hong Kong-Shanghai Stock Connect, overseas investors are still thinking through their A-share strategy. While some cannot wait to board the "through train", others are holding back.

"We will take a step-back approach first. A lot of overseas investors, especially foreign clients, would like to watch the stock connect run for a while before putting real money in," said Kelvin Wong, senior equity analyst of Bank Julius Baer, a Swiss private bank.

"We need a clearer picture of how it works," he said. "Details of the through train, such as trade rules and arrangements for dividend tax and capital gains tax, are yet to be decided. It may take longer than planned to launch."

The clock is ticking toward October, when the Hong Kong-Shanghai Stock Connect, commonly known as the through train, is scheduled. Northbound investors will be able to trade up to 568 A-share listed stocks under a net-buy aggregate quota of 300 billion yuan ($48.38 billion) or a daily quota of 13 billion yuan.

According to the latest information from the Hong Kong Stock Exchange, 111 participants have submitted their registration for the through train, accounting for 81 percent of securities market turnover in the city.

"Brokers can conduct system tests now, and market rehearsals are scheduled in late August to September," said the HKEx in a statement to China Daily. However, enthusiasm appears somewhat one-sided, as many overseas investors are still sitting on the fence.

"Through train is a good scheme, but we are worried about potential dark pool information leaking," said Paul Chan, chief investment officer for Asia ex-Japan at Invesco, a wealth management house looking after $802.4 billion in assets.

"According to pre-trade checking rules regarding when to sell A-shares, we have to transfer shares to brokers one day before trading," Chan said. "That generates a huge problem. How can we make sure word does not spread? It happened in the US. If information leaks, all high frequency traders would know by the next day. How can we protect the interests of our clients? We have to fix this first."

In response, HKEx told China Daily a settlement instruction session will be introduced every trade day morning to enable custodians to transfer A-shares, which is expected to shorten the time gap between the transfer of shares and selling transaction.

"We believe custodians and brokers may find the morning session run particularly useful to their institutional clients who may have difficulty meeting regulatory requirements of transferring A-shares to selling brokers one day before trading. We will monitor how it runs and consider if further adjustments would be required," said HKEx, adding at the same time, mainland authorities are aware of and working on the tax matters.

Factors hinder investors

Apart from undecided rules, other factors are also deterring overseas investors, said Peter Pak, executive director of BOCI Securities.

"Granted access the first time, many Hong Kong retail investors are not familiar with the A-share market, particularly when it comes to stock picking," said Pak. "Besides, given the limited capital and energy they have, retail investors would probably tend to pick up only one or two stocks, which makes the whole set of A-share rules too complicated to study.

"Adapting to a new market is certainly a piece of cake for fund managers because they do it all the time," he said. "However, for the time being, A-shares might not look juicy enough to them.

"By far most institutions are focusing on developed markets in the light of their slow but steady recovery," he said. "The developed market rally is expected to continue until the US Federal Reserve makes clear its timetable of interest rate hikes, which is estimated to be no earlier than the second quarter next year. Global capital may not flow back to emerging markets before that."

The MSCI World Index, the barometer of developed equity markets, has risen 5.25 percent to date to over 1,748, compared with the pre-crisis high of 1,682 in 2007. Earlier in July, US central banker Janet Yellen reassured investors that the Federal Reserve will not raise its interest rate abruptly just because of a potential bubble, which is believed to be market-friendly. On the contrary, the Shanghai Composite Index has been busy keeping its head above 2,000 for more than two years.

Fund managers are not likely to overweight Chinese companies only because the through train kicks off, Pak cautioned. "The new channel is not going to replace the share holdings made through QFII and RQFII," he said, "but institutions without enough quota may try the connect."

Upfront spending could also deter some brokers, as a new trading system would cost at least several million Hong Kong dollars.

"That certainly affects a lot of small securities houses," he said. "Traffic may not be significant at the beginning. It's a question about how long it will take to break even."

Arbitrage opportunity

Despite all kinds of hesitancy, data point to an arbitrage opportunity. "Currently, A-shares are much cheaper than H-shares," said Lu Wenjie, strategist of UBS. "Average valuations of H-shares used to be 30 percent cheaper than their mainland peers, but now it's about 10 percent more expensive. The A-H premium is at record high."

Hang Seng China AH Premium Index closed at 91.90 on Monday, which means an 8.1 percent discount for A-shares compared with H-shares on average. "Some blue chips on the mainland, such as banks and resources companies, are now 15 to 30 percent cheaper," Lu said. "The opportunity is great for these stocks to pick up. After the stock connect starts, we estimate valuations of A-shares to step up as much as 5 percent above their Hong Kong-listed counterparts.

"Besides, the existing QFII quota is tight and capital outflow still needs approval from the State Administration of Foreign Exchange," he said. "In comparison, the through train will be more convenient."

Asia Pacific investment strategist of Citicorp International Ltd Ken Peng said: "For overseas investors, low threshold is the key. You don't need a lot of money to participate in the through train. Most importantly, the A-H premium should not widen once the markets are connected.

"While one-third of Hong Kong-listed stocks are banks, nine in 10 State-owned, Chinese private companies mainly list on the mainland," he said. "We believe small cap stocks, especially in the healthcare and consumer sectors, will see capital inflows," he added. "When the overall situation improves, foreign investors will be happy to seek a return from this part of the world."