What difference can stock connect make to China's stock market?

More foreign capital will flow into China's A-share market starting next Monday when the Shanghai-Hong Kong Stock Connect formally kicks off.

Aside from injecting much needed liquidity into an anemic market, offshore investment is expected to induce greater changes to China's capital market.

The upcoming plan will allow offshore investors to invest in selected stocks listed on the Shanghai exchange, subject to a daily quota of 13 billion yuan (2.1 billion U.S. dollars) and a total quota of 300 billion yuan.

Once the stock connect is in place, it will create the world's second largest stock market by market capitalization, according to Goldman Sachs. Growing foreign participation will diversify the investor base and infuse the A-share market with mature investment strategy.

Zhu Haibin, J.P. Morgan's chief China economist, said that should foreign participation in China's domestic stock market be lifted from 2 percent to 5-10 percent it could potentially have a material impact over investment preferences in China's stock and bond markets.

Up until now, China has allowed institutional investors to invest in China's capital market through two quota-based programs: The Qualified Foreign Institutional Investor (QFII) arrangement, which was launched in 2002 and has since grown to a size of 64 billion U.S. dollars, while a similar scheme that allows foreign institutions to invest using the Chinese yuan raised from overseas has totaled 294 billion yuan.

Wang Hanfeng, a strategist with China International Capital Corp., said that the stock connect was the beginning of the further liberalization of China's capital market, especially as links to the Shenzhen Stock Exchange and continued expansion of the QFII and RQFII arrangements are in the pipeline.

In addition to increased volume flowing into China's A share market, the project has connected the Shanghai Stock Exchange with a truly global exchange offshore. Lin Caiyi, chief economist with Guotai Junan Securities, said the stock connect had prompted the Shanghai bourse to realign its trading rules with that of a mature market, a crucial step for the exchange to become a global market.

Shortly after the regulator released the launch date for the stock connect, the Shanghai bourse said it was mulling a pilot to allow investors to sell stock they bought on the same day, which although not allowed in Shanghai is a common practice in Hong Kong.

Hong Kong Exchanges and Clearing chief executive Charles Li Xiaojia also said on Monday that authorities had already resolved the tax issue around foreign investors'gains in the A-share market while margin trading and short selling would be allowed some time next year.

But analysts say the key force driving China's stock market reform has to come from within. China's domestic stock market was among the world's worst performing markets in 2013 and investors preferred quick gains over value investment.

Meanwhile, inadequate protection of China's retail investors, who make up more than 80 percent of the market's trading volume, have left them vulnerable to accounting fraud and lax information disclosure of listed firms.

The Securities Regulatory Committee, China's top security watchdog, has pledged to reform the country's IPO system from an approval- to a registration-based one. It is also strengthening information disclosure and investor protection. Meanwhile, a new set of de-listing rules is expected to come out and more harsh penalties will be introduced against fraudulent issuers.

However, the urge to increase the weight of Chinese equities in global asset managers'portfolios will outrun concerns over some of the market's persisting problems and the daily quota of 13 billion is expected to be filled up once the plan is launched.

"Investors will focus on listed companies' earnings and whether ongoing and future reform initiatives will deliver. The downside risks of the Chinese economy have already been priced in and shares will be buoyed if investors are convinced that reforms are positioning the Chinese economy on a more sustainable track, J.P.Morgan's Zhu said.