There are few things like a bull market to turn an investor’s head. Just look at China. Having slumped almost 50 per cent from its peak last June to a low in early January, the benchmark CSI 300 Index is now up 20 per cent.
The memory-erasing qualities of this year’s rally in Shanghai will soon be given a real test as a trading link between Hong Kong and the stock market in Shenzhen will make it far easier for investors to gain exposure to the shares of Chinese companies listed on the mainland.
The link to the Shenzhen market, or Stock Connect, as it’s known, could open as early as next week and, together with an existing trading link between Hong Kong and Shanghai, will be the only direct route available for foreign investors to trade mainland stocks without prior approval from authorities in Beijing.
So will foreign investors be lining up to buy?
Shenzhen versus Shanghai
The drawcard for Shenzhen is greater access to some of China’s most sought-after technology companies, with some analysts viewing this as one reason Shenzhen’s appeal could easily rival, if not exceed, that of Shanghai, whose bourse is dominated by state-owned enterprises and older industrial businesses.
“You look at the Shenzhen SME board, the ChiNext board and they are expensive, but you cannot deny quite a lot of the new interesting Chinese tech companies and new start-ups have started to come to these two markets,” said Vincent Chan, head of China macro research at Credit Suisse. “For foreign investors, I would say Shenzhen is more important than Shanghai right now.”
The Shenzhen Stock Exchange, just over the border from Hong Kong, has become the nexus for the listed technology, consumer and healthcare companies that are at the forefront of China’s new economy. While ChiNext, a market with lighter listing standards, played host to some of bubbliest companies during the 2015 boom and slump, with some trading on four-figure price earnings multiples. Indeed, to begin with the 200 ChiNext stocks that can be traded will only be offered to institutional investors, not retail, because of their high-risk nature.
In total, the link with Shenzhen will add 880 stocks to the 567 already available to foreign investors through the Shanghai link.
International exposure to China
So far most foreign exposure to mainland Chinese companies has come through those listed in New York or Hong Kong. As recently as early 2016, foreign ownership of Shenzhen A-shares, or those listed on the Chinese mainland, was less than 1.2 per cent, according to data from China’s securities regulator. That is a fraction of foreigners’ 46 per cent share in Hong Kong, 26 per cent in Japan, or even 23 per cent in Russia. Even including Shanghai, international investors account for only 2 per cent of investment in mainland markets.
The two Connect schemes will cover an estimated 80 per cent of China’s mainland market capitalisation, handing foreign investors almost full access to the A-share market through Hong Kong. Turnover in Shenzhen in the first nine months of the year was $9tn, the fourth-highest in the world, according to data from the Shenzhen Stock Exchange and World Federation of Exchanges.
Steven Sun, head of China and HK equity strategy at HSBC, thinks that despite high valuations of the Shenzhen A-shares, “which to some extent can be justified by higher growth, better liquidity and a small-cap premium” there are two main reasons to invest in the market.
Firstly, it has “the lowest correlation to global equities compared to the Shanghai A-share market and the Hong Kong stock market” and secondly, the high dispersion of returns means “more stock-specific risks and more alpha opportunities for active managers”.
‘Southbound’ flows and the renminbi
Investors and analysts will also be watching “southbound” flows through the Connects — those from Chinese mainland investors into Hong Kong — which can act as a hedge against renminbi depreciation even though the Connect’s closed loop means investors buy or sell in their starting currency.
The depreciation of the renminbi has had a “tremendous impact” on Stock Connect flows this year, according to Nicole Yuen, head of Greater China equities at Credit Suisse.
So-called southbound purchases from the mainland picked up in the second half of this year as the renminbi’s decline gathered pace, with investors favouring high-yielding stocks and dual-listed names in Hong Kong that were trading at sizeable discounts to their Shanghai cousins.
Likewise, northbound purchases cooled as international investors became less bullish about China after the bursting of the 2015 bubble and angst about the growth outlook. The 30-day average of northbound purchases is now about a quarter of the average Rmb6.25bn ($917m) reached at the peak last summer.
“At the moment I would say one of the main reasons for the increased southbound flow is because of the expectation of the depreciation and the more subdued interest into the northbound flow again is also due to the market expectation the renminbi may go down further,” Ms Yuen said.
Steps in the right direction
Underlying all the interest in Shenzhen is how the trading links allow direct access in and out of China – a key sticking point for MSCI, the index provider which this year cited the inability to easily sell shares as a reason for its decision not to include A-shares in its widely-tracked stock indices.
Running alongside the Connect schemes is the QFII, or qualified foreign institutional investor schemes. These require Beijing to individually approve each investor, which is a lengthy proocess and does not allow investments to be repatriated at will.
“QFII was the preferred option for international investors, but since the renminbi depreciation and the abolition of the aggregate quota, Stock Connect has become a more popular choice,” said Christina Ma, head of Greater China equity sales at Goldman Sachs.
Coming on top of Beijing’s opening up of its vast interbank bond market earlier this year, the deepening of links between equity markets on mainland China and international investors, suggests authorities are serious about the internationalisation of Chinese markets.
“First Shanghai then the interbank market and now Shenzhen: the direction of travel is clear,” said the regional head of trading for one large fund manager. “The Shenzhen volumes won’t be huge to start with but that’s not the point — which is we will now build on these links once they’re there.”
