September 2016

SHENZHEN: A new line

ShenzhenChina's second-biggest stock exchange, in Shenzhen, will soon be open to investors in Hong Kong. Will they want to buy? George Mitton reports. A market town situated on the railway route connecting Hong Kong and the mainland, Shenzhen made relatively little impact on history until 1980, when it was declared the first of China’s special economic zones. Since then, the city’s population has leapt from 30,000 to more than ten million as manufacturing, service and high-technology industries have sucked in billions of foreign investment. The boom of the last three-and-half-decades has turned Shenzhen’s port into one of the world’s busiest and its stock exchange into the second-biggest in the country after Shanghai. Shenzhen’s fame continues to rise with the recent confirmation by China’s State Council that a scheme to link its stock exchange with that of Hong Kong has received approval. The scheme, a recreation of the Shanghai-Hong Kong Stock Connect, which went live in November 2014, will allow international investors on the Hong Kong exchange to buy Shenzhen-listed stocks. Mainland investors in the Shenzhen exchange will enjoy the same rights on the Hong Kong exchange. The Shenzhen Connect is set to launch by the end of this year. So, what can investors expect? EXCITEMENT?
International investors have good reason to participate in Shenzhen’s exchange. A number of China’s most interesting listed companies are traded there, including whizzy IT and software firms. For fund managers who seek exposure to the ‘new’ China – young companies involved in the technology and service industries, as opposed to the ‘old’ China of lumbering heavy industry and state-owned enterprises – it is important to have exposure to Shenzhen. Indeed, fund managers have welcomed the move. Jing Ning, portfolio manager at Fidelity International, says the Shenzhen Connect is “a step in the right direction in terms of increasing institutional participation in mainland China’s stock markets”. Her fund already invests in Shenzhen-listed stocks using Fidelity’s qualified foreign institutional investor (QFII) quota; the Shenzhen Connect will make the investment process simpler. CLEAN DESIGN
The design of the scheme is also a source of optimism. Unlike some of the other access schemes by which China allows foreigners to enter its capital markets, such as the aforementioned QFII scheme, Stock Connect is not subject to a case-by-case approval process. The simplicity of the scheme has been praised by index-maker MSCI, among others, which has said it is the “most promising” of the access routes in terms of gaining emerging-market status. Any investor in Shanghai with at least half a million renminbi, and any investor at all on the Hong Kong exchange, can participate in the existing Shanghai Connect. The same rules will apply to the Shenzhen extension. There is no need for lengthy waiting periods for licence approval. As Aidan Yao, senior emerging Asia economist at Axa Investment Managers, puts it, “what really sets the Stock Connect apart from others is the clean design of the system that minimises official interference and maximises investor inclusion”. The scheme, in fact, is about to get even more straightforward. In announcing the Shenzhen Connect, the Chinese authorities dropped the aggregate quota for both the Shenzhen and Shanghai routes. There remains only a daily quota of 13 billion renminbi on the northbound route (Hong Kong to Shanghai) and 10.5 billion renminbi on southbound. TIME FOR A RALLY
Could the launch of Shenzhen Connect drive a rally in Chinese equities? That is less certain. For one thing, the Shenzhen exchange is expensive, with valuations that are on average nearly 50 times earnings, compared with 12 times earnings for stocks on the Hong Kong Hang Seng index and 17 times for Shanghai, according to figures prepared by Yao. The high prices are “a big hurdle for offshore institutional investors to overcome”, he says. Given the price differential, some analysts expect more traffic on the southbound route of the Shenzhen Connect, when investors in the mainland use the new stock link to buy Hong Kong-listed shares. Hong Kong listings of dual-listed stocks are currently about a quarter cheaper than their mainland-listed equivalents, which Chinese investors might see as a buying opportunity. Another negative point is that volumes are unlikely to be large enough to make a significant difference to overall Chinese equity values. Northbound flows on the Shanghai Connect – that is, money invested in Shanghai stocks by Hong Kong investors – typically accounts for between 0.2% and 0.4% a day of market turnover. “These flows are simply too small to exert a tangible influence on price actions,” says Yao. DIRECTION OF TRAVEL
However, even if the immediate impact of Shenzhen Connect is small, its significance as an indicator of China’s capital markets policy is large. The Chinese authorities may have announced the scheme’s official approval in August deliberately so as to pre-empt the G20 meeting on September 4-5, allowing the Chinese to demonstrate a continued commitment to opening up its capital markets. The move is a clear signal that China is moving towards more openness. That openness has ramifications for index makers. The improved access Shenzhen Connect will offer to international investors increases the chances that Chinese mainland-listed shares will be included in the Emerging Markets index from MSCI at the next review in 2017.  That inclusion, if it comes, would trigger large inflows from funds that track the index. The extension of the scheme is also significant for Hong Kong, whose status as the principle access route to China is confirmed. “Combining the A-shares included in the Shenzhen-Hong Kong and Shanghai-Hong Kong Stock Connect programmes, as well as Hong Kong-listed shares, we will be looking at the second-largest equity market globally by market cap, traded through Hong Kong,” says Jian Shi Cortesi, portfolio manager at Swiss asset manager GAM. FUTURE
There are more developments on the horizon. As well as confirming Shenzhen Connect, the Chinese authorities surprised the markets by revealing that, some time in 2017, exchange-traded funds (ETFs) would become eligible to be traded under each of the Connect schemes. The most interesting aspect of this change is that it would allow mainland Chinese investors to buy Hong Kong-listed ETFs to diversify their portfolios. That would offer a golden opportunity to Hong Kong-based ETF providers, who would get instant access to the most populous country on earth. The Connect system may offer a simpler way for them to gather inflows from the mainland than, for instance, the mutual fund recognition scheme, in which funds must gain individual approval to participate. That points to more work for fund providers in Hong Kong, and more cross-border money flows between it and the mainland. The Shenzhen Connect is only the beginning. ©2016 funds global asia

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