12th April 2014
Mark Tinker, head of AXA Framlington Asia, has put together his thoughts on the short and long term implications for both markets, stocks and China of the decision to allow, subject to quotas, investment between the two Hong Kong and Shanghai stock markets. This is one of the technical pieces Mr Tinker publishes weekly, but with potentially huge implications, we thought it might help those readers who really want to get their heads round the issue.
The announcement this week by Chinese Premier Li Keqaing confirming the ‘through train’ plans to connect Hong Kong and Shanghai stock exchanges caused a flurry of excitement in both markets. The short-term response has, naturally, been all about a trading arbitrage, but we should also focus on the medium-term positives and put the announcement in the broader context of structural financial reform in the region.
The proposal is for a pilot scheme that will take around six months to implement and is thus likely to arrive around in October and comes with a number of quota restrictions. These will likely be relaxed over time, but for now the southbound quota – i.e. mainland investment into HK – is RMB 10.5bn per day, with an aggregate annual total of RMB 250bn. To put this in context, this daily quota is equivalent to around 20% of the average daily turnover in the Hong Kong market so would be a welcome lift to liquidity. Northbound, the quota is RMB 13bn per day with an aggregate of RMB 300bn. While this is a lower proportion of Shanghai’s average daily turnover, the proper context perhaps is the current, QDII, QFII and RQFII quotas. Goldmans calculate that as at 28th March, the cumulative quota granted for Qualified Foreign Institutional Investor (QFII), the amount foreign intuitions can invest in China A shares, was US$3.58bn, with a quota cap of $150bn. Meanwhile the cumulative quota for Remnimbi Qualified Institutional Investor (RQFII) was RMB 200.5bn (US$32.3bn) with a quota cap of RMB 1,510bn (SU$243.5bn). Finally, Qualified Domestic Institutional Investor (QDII), the scheme to allow Chinese residents to invest abroad via certain fund management companies and institutions, has a cumulative total granted of US$86.59bn. Thus, we see that the southbound annual quota is around 46% of cumulative QDII while the northbound annual quota is 56% of QFII and RQFII combined.
The immediate reaction has been to arbitrage the difference between the A and H shares where there has been a dual listing. Bloomberg calculate an Aggregate Index of the AH premium which tracks the extent to which the A shares are at a premium to the H shares, and we can see from the graph below that the premium has indeed closed a small amount.
Source Bloomberg 11/04/14
However, this is more about the individual stocks and in some cases the spread has been dramatic, for example auto parts company Zhejiang Shibao, where the H share has traded at a discount to the A share of 81% jumped 58% yesterday, while companies such as Conch where the H share trades at a premium saw the gap narrow by the A shares jumping 7% while the H shares fell a similar amount. Brokers have been busy firing off spreadsheets, but most fund managers with access to Bloomberg can download their own and monitor what is going on. The arbitrage undoubtedly reflects something of a liquidity constraint as well as different buying preferences and the range of premium and discount is far wider than might perhaps be inferred from the aggregate discount. The chart below is a snapshot from the XARB spreadsheet sent out by Bloomberg and shows where the H shares are at a premium to the A shares and vice versa – above the line, H is premium to A.
Distribution of Premium and Discount, H to A shares
Source Bloomberg Axa-IM 11/4/14
Over time therefore the differences are likely to be arbitraged away, but there are many underlying factors behind the spreads so investors should tread carefully. The other beneficiaries are likely to be Chinese household names that are listed in Hong Kong but not Shanghai – such as the Macau stocks, Tencent, Lenovo, Samsonite, Tingyi and Mengniu , as well as the exchanges themselves. It should also push along the ability of the MSCI to include A shares in the EM Index which would lead to a new range of investors and, perhaps, valuation arbitrage.
There is still some detail to work out, for example, while the Southbound train is open to all Chinese institutional investors and private investors with a certain amount of capital, it isn’t clear for example who exactly is eligible to invest on the ‘northbound train’. The document set out qualifications for domestic investors, but didn’t mention the qualification for foreign investors. Clearly though, to the extent that the QDII scheme was investing in HK shares, this looks like it will be replaced by the southbound through train while obviously the QFII and RQFII schemes will be merged onto the northbound train in so far as they are channelled through Hong Kong. This latter point always made sense to me, why would China, with its own, well established offshore financial centre in Hong Kong, not tilt the playing field to its benefit? Under the scheme, mainland investors would not need a HK brokerage account, with the key benefit to the mainland Chinese authorities that they can effectively monitor investment activities, although there is a need to resolve different settlement cycles. Meanwhile, A shares become international straight away, likely trading in CNH, the offshore RMB, further pushing the role of the RMB as an international transaction currency.
More broadly, there should be no reason why the programme should not be extended to other listed financial products and most likely to be denominated in RMB, something which obviously speeds up the time when the Hong Kong dollar starts to be superseded by the RMB.
The markets remain concerned about the possible disruption from all this reform and while not entirely sanguine, we think it is important to work out ‘how’ the process will unfold, rather than just declare that we are ‘worried about it’. In my opinion, the Chinese authorities are still in control of the speed of the reform, even if they cannot now reverse it, rather like being on a mountain bike at the top of a steep hill, going down the gravitational momentum is the main motive force so you start with brakes full on and let them out bit by bit trying to avoid going too fast, but also trying to be smooth so as not to skid or tip over the handlebars. To extent this analogy, allowing some trust products to fail is letting off the front brake a little, as is this through train announcement, speeding up, but still very much in control.
My economist colleague Aiden Yao put out a very interesting paper last week on the shadow banking system in China in which he made the key point that the system is very different to that in the US for example, which was outside of the banking system in many ways, and was acting more as a shadow capital markets system. In China, the shadow banking system is very much a banking system and has been encouraged to be so by the PBOC as part of the ongoing reform process. It seems clear that allowing the internet companies Tencent and Alibaba to introduce money market funds has hastened a de facto liberalisation of interest rates, enabling the PBOC to accelerate their own plans to shake up the bank sector. Savers get double the return that they would get on time deposits, but instant access and the recycling of those funds into interbank CDs arguably helps out banks that would otherwise struggle for liquidity. The trust products are now the ‘main concern’ of the China bears, with hyperbole about a Lehman moment and with a lot of the trust products issued in 2012 on a 2 year life, there will be many billions of RMB of these rolling off over the next 12 months. Undoubtedly, there will be some losses, but the PBOC is clearly aware of the moral hazard issues and will likely take the opportunity to introduce some form of deposit insurance scheme, happy to see the Trust products die out naturally as domestic Chinese liquidity finds a ‘better’ home. Perhaps in the same way, opening up the equity markets may hasten a de facto capital allocation to good companies (those that give returns to investors) and allow a shake up of slow moving corporates used to captive capital.
Property of course is another loser under this opening up of capital markets and is clearly showing signs of pressure; residential property sales in the big 12 mainland cities (admittedly a volatile series) were down 36% yoy in March 2014 and obviously with the prospect of better, more liquid homes for their savings the investor-led inflow is likely to continue to slow. As noted last week though, the nature of home ownership in China, even second, third and fourth homes, is very ungeared, so the likelihood of foreclosures and distressed selling is very small. Individuals would take most of the mark to market hit while developers would run into huge negative operational gearing which might cause a problem for some banks. The most likely transmission to the real economy might be through collateralised lending on property and land banks, a reassessment of which might be the most likely cause of a liquidity problem.
The net result of all this change is that bottom up investors should still have the opportunity to outperform a benchmark that is biased towards slow moving and inefficient companies. As CLSA point out, while MSCI china looks cheap on 8.8x one year forward earnings, if we strip out the banks, this is nearer 15x. Meanwhile, Strategist Chris Wood points out that in a wider Asia ex Japan context, almost half of the CLSA universe had a dividend above US 10 yr Treasury yields and 36% were forecast to have a yield above their own local bond market yield.