Stock Connect: A Major Change for Chinese and World Equities

On November 17 an important change in the Chinese stock market will take place which will likely have very important long term consequences for not only the Chinese stock market but for the global equities market. Stock Connect will give non Chinese investors access to onshore Chines A Shares and allow mainland Chinese investors access to shares trading ont he Hong Kong exchange.

As Reuters reports

(Reuters) - A long-awaited trading link between Hong Kong and Shanghai will launch on Nov. 17, a crucial step towards opening China's capital markets that will give foreign and Chinese individual investors unprecedented access to each others' stock exchanges.

The announcement by Hong Kong and Chinese regulators on Monday comes as China is making a big push to widen the use of the yuan, with Canada and Malaysia becoming the latest addition to a growing list of trading hubs for the currency.

The so-called Stock Connect trading scheme could boost the average daily value of stock trading in Hong Kong by about 38 percent by 2015, French bank BNP Paribas estimates, and may ultimately lead to the creation of the world's third largest stock exchange.

The project will at the same time provide a channel for Chinese savers to start moving some of the $8 trillion of private wealth currently in deposits into overseas stocks.

This graphic from the WSJ article on the subject  is a useful overview of the changes

The consequence of this change  is to give foreign investors more than their limited access to stocks listed on the Shanghai market (A shares) and Chinese investors access to shares of Chinese companies traded on the Hong Kong exchange (H shares which are included in the Hang Seng Index). Many companies dual list.

The long term impact of this change is potentially far greater than the near term impact. China’s “economic footprint” is far larger than it’s representation in global stock indices and in the portfolios of global investors. That is because of the limits of accessibility to the Chinese market. A shares have not been included in the emerging market indices. The stock connect will have important long term implications as this analysis in the FT by a Goldman Sachs researcher explains:

The long-term implications for the Chinese market are tremendous. Foreign ownership of A shares, which stands at less than 5 per cent of free float through the current quota systems, will increase as these stocks are added to global equity indices.

There will also be changes to fund allocations, as China is under-represented in global equity benchmarks. It contributes more than 12 per cent of global GDP and a similar share of world trade, but has a weighting of just over 2 per cent in the MSCI All Country World Index. The inclusion of A shares in global equity benchmarks could trigger as much as $21bn of incremental fund allocations to China by 2016.

In the long term, Stock Connect will integrate A shares with Hong Kong shares to create the world’s second-largest market by value. Size aside, it is a market of increased relevance to global investors who are seeking more exposure to China. The integration of A shares into global indices will allow investors to capture China’s growth more broadly and access opportunities that are only available in domestic markets at present. It will also allow international investors to refine their exposure from large-cap oil, telecom and banks towards sectors offering more focused exposure to domestic consumption such as health care and media.

Stock Connect is a big step forwards in further liberalising China’s A share market, creating unprecedented opportunities for investors worldwide. It is also an important component of China’s market reforms including renminbi internationalisation, which will elevate the country’s standing in the global economy

A Bloomberg article gives an idea of the implications of the addition of A shares to the major emerging markets index 

…A-shares could eventually be a 10 percent weighting in the MSCI Emerging Markets Index, according to MSCI. The index has $1.4 trillion of assets that use it as a benchmark. That means over $100 billion worth of demand could come from being included in that one index, albeit incrementally. 

The impact on the MSCI all world index would be to near double the weighting of China from under 2% to a bit under 4%

ETFs and Stock Connect

There are around half a dozen ETFs that invest in A shares. They have been established in partnership with Hong Kong brokers who have been permitted to buy A shares (qualified foreign institutional investors: QFII) An indication of potential interest in this sector is that over 15 ETFs in this sector are currently under registration but not listed.The largest and most liquid of these is ASHR 

ASHR has traded higher all year and has gotten a further lift as the stock connect date has approached moving up 8% in the last 3 months.

But the underlying index still trades at a p/e of 8.9, a significant discount to the overall emerging markets as well as of course the US. So on both a valuation basis and the long term prospects of large inflows there may well be significant long term opportunities in this sector.