Market discrepancies cloud Stock Connect scheme

Illustration: Chen Xia/GT

Legal questions, hedging options could curtail benefits of trading program

Most of the world's major stock markets have recovered from the financial tumult of 2008. In Asia, nearly all of the region's stock indices have set new record highs since the global financial crisis - with the exception, of course, of those on the Chinese mainland and Hong Kong. Since mainland-based enterprises account for about half of the businesses which compose the benchmark Hang Seng Index, sluggish conditions on the H-share market are broadly reflected in onshore equities.

Over recent years, Chinese authorities have struggled to pump fresh life into anemic A shares, but to little avail. Investors pulled their money from onshore-traded stocks, resulting in a dearth of liquidity. Looking ahead, the impending launch of the Shanghai-Hong Kong Stock Connect scheme, which allows investors on the mainland to trade shares listed in Hong Kong - and vice versa - may help revitalize confidence in A shares.

Major economies in Europe and North America were severely damaged during the financial crisis. Riddled with debt, many Western countries experienced prolonged periods of weak demand and high unemployment. This had an obvious impact on corporate groups and companies on the mainland. Facing a broad downturn in developed markets, many local businesses focused on raising capital to fund industrial upgrades. To keep the wheels of growth spinning, local governments got into the act, raising trillions of yuan to fund investments in fixed assets and infrastructure projects.

It's hardly been a secret that private enterprises on the mainland have long had to contend with an unfavorable credit environment. Given regulatory measures to restrain financial market access on the mainland - including a long-running ban on new IPOs - many enterprises have found it increasingly difficult to satisfy their funding needs from onshore stock markets.

The Stock Connect program can bring professional foreign investors and new capital into the A-share market, restoring investors' confidence in the process. Newly arrived foreign investors can help accelerate financial market reforms and pave the way for an internationalized, fully convertible yuan.

Opening the mainland market to the rest of the world can provide a solid foundation for business growth by filling funding shortfalls left by local banks. But owing to disparities between Hong Kong and the Chinese mainland, three issues need to be addressed.

First, Hong Kong and the mainland have distinct legal systems. In Hong Kong, any investor or company found guilty of manipulating the stock market will face severe punishment. Such stringent oversight and attention to market discipline have been crucial to Hong Kong's success as a financial center. On the mainland though, punishments for fraud and market misconduct are typically mild and inconsistently administered, which only breeds further abuses. Under the Stock Connect program, if a market participant on the mainland is suspected of improprieties, authorities in Hong Kong are in no position to investigate. Similarly, determining which laws to follow when punishing offenders also presents a thorny problem.

Second, mainland markets still lack derivatives or other tools that can help investors hedge against risks. When word breaks that a large institutional investor intends to buy or sell a particular mainland-listed stock, it is not uncommon to see that stock hit the 10-percent daily gain or loss limit. Once the Stock Connect program is officially launched, big foreign investors may take advantage of this common phenomenon and try to use derivatives overseas to profit from unskilled market participants on the Chinese mainland.

Third, recent years have seen several reports of publicly traded companies filing fraudulent earnings reports in stock markets around the globe. Mainland companies, both those trading on domestic as well as overseas exchanges, have also taken their share of heat from allegations of accounting manipulation and managerial malfeasance. As foreign investors move into the mainland capital market, they will surely want to see more forceful legal safeguards to protect them from losses stemming from companies' illegal actions. For the time being though, options for redress in such circumstances are limited on the mainland.

Undoubtedly, the Stock Connect is a far-reaching policy decision, one that needs an effective regulatory framework to guarantee its healthy development. Financial market participants all over the world are known for their ingenuity when it comes to finding and exploiting systemic loopholes for their own profit. This means mainland financial authorities cannot wait when it comes to strengthening the country's stock markets.