Quick Note:China Investor Forum 2014 takeaways

Outstanding technical issues: more clarification by kick-off in Oct

    We found great enthusiasm among offshore and onshore investors at ourlunch keynote and subsequent Shanghai-HK Connect tour as part of ourChina Investor Forum in Shanghai last week. Mr. James Fok, Chief of Staff& Head of Group Strategy of Hong Kong Exchanges and Clearing (HKEx),confirmed that there had been rising number of investors visiting HKEx in thepast few weeks to learn more about the company itself, the Stock Connectprogram, and the overall Hong Kong market conditions. However, we alsoheard concerns about technical details of the Stock Connect programmesamong investors, as ambiguities related to capital gain tax issues,functionality of the custodian system and stock borrowing and lendingmechanisms remain unresolved. According to information from the ShanghaiStock Exchange (SSE), these technical issues will be clarified or evenresolved before the Stock Connect is formally launched in October.

    Divergent preference: One man’s meat is another man’s poison?

    One of the most frequently asked questions by investors this time was towhat extent valuation convergence may occur and how investors couldutilise this opportunity. While most agreed that the large-cap bluechipstocks in the A-share market and the small- and mid-cap stocks in theHK market are where relative valuation is compelling, most investors wespoke to agreed that convergence will occur over time due to difference ininvestment preference among the A and H-share investors, rather than thetop-down macro views on China. We note that onshore A-share investorsare likely to utilise their ability to conduct thorough due diligence to gain aninformation edge over under-covered stocks trading in HK, even if they arenot currently on the eligible stock list, and that offshore investors may bedrawn to “growth at a reasonable price” (GARP) or paying slightly more forsustainable growth albeit not super charged growth, due to offshoreinvestors’ lower cost of capital and lower return requirement, vs. onshore Ashareinvestors.

    Northbound quota could be lifted more readily than Southbound

    Officials from SSE and the Stock Exchange of Hong Kong (SEHK) we metindicated that the current trading quota limits are necessary so as to ruleout anticipation of huge inflows of hot money into HK and/or A-shares, whichhappened during the anticipated trial of the “Through-train”programme in 2007. Mr. Fok from HKEx noted that the Northbound quota iscontrolled by the China Securities Regulatory Commission (CSRC) and theSouthbound quota is controlled by the Securities and Futures Commission(SFC) of Hong Kong, and that the two regulators would work togetherclosely on this issue. A key determinant for regulators when consideringquota relaxation/removal would be no huge fund flows interrupting thestability of the two markets. Anecdotally, we understand that regulatorsmight review the aggregate quota limits when the quota usagerates persistently hit 80%. We understand that the CSRC may more readilyrelax the Northbound quota limit vs. the SFC, which may have to consider the impact on the HK-dollar peg. As such, on the margin, development onthis front could be more favourable to A-shares than to H-shares.

    A lot more “Connects” to come: derivatives, commodities, FICC

    While expanding the Stock Connect programme to include the ShenzhenStock Exchange would be a relatively straightforward step to take, HKEx isalso considering cooperating with mainland institutions to build connectsin other asset classes.

    Derivatives: Adding derivatives into the connect programme couldpotentially bring meaningful trading volumes to Hong Kong’s derivativemarket. According to information from the HKEx, while there are only~100k eligible investors in the mainland derivative market, 700k contractsare traded every day on average on the HKEx, vs. 500-600k contractstraded on the SEHK each day on average. Bringing mainland investorsinto the Hong Kong derivative market may add to the liquidity of HongKong’s derivative market. However, as there is no single stock optionmarket in mainland China, the mainland regulator might be reluctant tohave Hong Kong as the pilot place for A-share single stock options in theshort term. Index-linked futures might be more acceptable by theregulators and could offer investors the basic index overlay hedges.

    Commodities: In terms of commodities, HKEx took over the LondonMetal Exchange (LME) in 2012 and will launch LME Clear this month,which is expected by HKEx to add USD19mn incremental revenue on anannualised basis. While HKEx claimed that the takeover of LME was aprofitable deal in itself, some investors believed that it was a strategicmove made by HKEx targeting possible cooperation with onshorecommodity exchanges to benefit from China’s status as the biggest globalcommodity buyer.

    FICC: Moreover, as Stock Connect is widely perceived as an integral partof the RMB internationalisation project, there may be various opportunitiesfor exchange companies and securities firms to explore with respect toRMB-denominated fixed income and currency products. We expect to seemore FICC derivative products coming up, helping mainland investors andmainland banks with risk transfer and currency hedges.