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Ever since China’s stocks started to unravel in June 2015, the government has attempted to stabilise and boost its capital markets. Dozens of policies have been deployed, mostly without success, including bans on short selling, rate cuts and a relaxation on pension fund investing rules. Beijing’s latest big bet is Shenzhen, the former fishing village that is today known as the ‘Silicon Valley of hardware’.
Situated just 11 miles north of Hong Kong, Shenzhen was designated China’s first Special Economic Zone back in 1980 and is today home to the world’s fifth largest stock exchange – the Shenzhen Stock Exchange (SZSE). It has an average daily stock exchange turnover of $80bn – just behind New York, according to the World Federation of Exchanges data – and so Beijing has decided to give the green light to a scheme that it first initiated in 2014.
On 16 August 2016, China and Hong Kong’s securities regulators – China Securities Regulatory Commission (CSRC) and Securities and Futures Commission of Hong
Kong (SFC) – jointly announced approval to the establishment of the Shenzhen-Hong Kong Stock Connect. Delayed for more than a year due to China’s 2015 stock market crash, the launch of the Shenzhen scheme – expected to be operational by the end of 2016 – provides mutual stock market access between Hong Kong and Shenzhen via a Northbound Shenzhen Trading Link and a Southbound Hong Kong Trading Link (see box).
Former Co-Chair of the IBA Technology Law Committee;
Co-Head of the International Practice and a partner at Ropes & Gray
The reasons behind the precise timing of the approval from Beijing are open to conjecture. Some see it as tied to China’s failure in June 2016 to secure the inclusion of its domestic A shares on the emerging markets index of the world’s largest stock index provider for the third year in succession. Morgan Stanley Capital International (MSCI) cited accessibility concerns for international investors as the main cause of its rejection, which came as a huge setback for a country increasingly eyeing foreign capital to prop up a downward economy.
Harry Rubin, former Co-Chair of the IBA Technology Law Committee and Co-Head of the International Practice and a partner at Ropes & Gray in New York, says: ‘As interest in emerging market shares recovers, China needs to find a way to attract its fair share of global investors. Shenzhen opens the door that was closed by MSCI.’
While foreign investors have been able to directly buy stocks in Shanghai since November 2014, they have needed a special licence to purchase Shenzhen shares. The Shenzhen scheme, however, removes this hurdle, providing global investors with direct access to a market that has consistently grown faster and delivered better returns than Shanghai for the past decade.
On paper, the Shenzhen scheme should enable foreign investors to diversify their portfolios, as the SZSE is a multi-tiered capital market providing liquidity for 880 companies at different stages of development, including small and medium businesses and tech start-ups.
The main framework of the Shenzhen scheme resembles the one under a similar link between Hong Kong and Shanghai, launched in November 2014. For eligible shares, this means:
Northbound Shenzhen Trading Link
– includes any constituent stock of the SZSE Component Index and SZSE Small/Mid Cap Innovation Index with a market cap of RMB6bn ($900m) or above, and all SZSE-listed shares of companies that have issued both A shares and H shares. At the initial stage, only institutional professional investors are eligible to trade shares that are listed on the ChiNext Board of SZSE; and
Southbound Hong Kong Trading Link
– includes constituent stocks of the Hang Seng Composite LargeCap Index and Hang Seng Composite MidCap Index, any constituent stock of the Hang Seng Composite SmallCap Index that has a market cap of HK$5bn ($650m) or above, and all Hong Kong Stock Exchange-listed shares of companies that have issued both A shares and H shares.
In addition, Chinese regulators say there will be no cap on the aggregate market quota imposed under the Shenzhen scheme, while the previous cap on shares that could be held by offshore investors through the Shanghai scheme has been removed.
The scheme will also provide foreign investors with greater access in general to Chinese stocks as a result of the demise of aggregate quotas, as well as access to a broader range of financial products. The CSRC and SFC have already approved the 2017 rollout of exchange-traded funds, while other products will be considered if they help investors manage price risks in both markets.
But perhaps the most anticipated benefit from the new scheme is that foreign investors will, for the first time, be able to invest directly in China’s so-called ‘new economy’ plays, such as biotechnology, green energy, high-end manufacturing, information technology, media, new energy vehicles and new materials.
‘With China’s economy undergoing a transition from relying on heavy investment to becoming more consumer-oriented,’ says Jan Bogaert, a partner at Stibbe in Hong Kong, ‘those “new economy” companies should be a better proxy to track and benefit from China’s future growth than the heavy Shanghai-listed moguls.’
The Shanghai market is dominated by state-owned energy firms, notably heavy industrial companies that have been badly affected by China’s economic slowdown. The country’s state-owned banks, weighed down by a legacy of non-performing loans to state industries, are equally unappealing to foreign investors. Even if such investors wished to hold stakes in any of these entities, they are more likely to do so in Hong Kong, where many of them are also listed and at cheaper valuations than in Shanghai.
‘The old economy sector has not captivated the imagination of the investor community for some time now, and not just in China,’ comments Rubin. ‘With its heavy focus on knowledge, intellectual property and innovation-driven companies, Shenzhen could do well.’
Investors have so far only taken up about half the quota under the Shanghai scheme, which has fallen short of expectations, due in part to doubts over the quality of financial information, regulatory actions following last year’s stocks collapse, and the ongoing availability of alternative trading routes.
Partner at Stibbe
‘An expansion of the Stock Connect scheme into Shenzhen may contribute to reviving investor interest in mainland China stocks by allowing them to diversify more than they currently can,’ says Bogaert.
Shanghai-based Co-Chair of the IBA Asia Pacific Regional Forum, and a partner at HJM Asia Law, Caroline Berube adds that the two exchanges are not in competition with each other. ‘Shanghai and Shenzhen target two different markets of investors in terms of type of companies, size of companies and industries,’ she explains. ‘Some investors may invest in both, some may select one. They now have options, and it is up to their own discretion to decide whether to invest or not.’
On news of the Shenzhen scheme’s approval, Hong Kong’s Financial Secretary John Tsang said it would ‘further strengthen Hong Kong’s status as an international financial centre’. While more than half of stocks listed in Hong Kong are already backed by Chinese capital, the scheme will enable Chinese investors to move more of their money offshore and away from weak onshore markets.
‘The Shenzhen-Hong Kong Connect will attract an additional class of professional, contribute to Hong Kong’s human capital, and create additional liquidity for Shenzhen shares,’ says Bogaert. ‘Trades presumably will run through Hong Kong, and this in itself may reinvigorate interest and investment in Hong Kong listed shares,’ adds Rubin.
However, while the launch of the Shenzhen scheme should be regarded as a significant development in China’s 26-year old capital markets, relatively high valuations in the Shenzhen market and a slowing national economy are likely to see foreign investors continuing to exercise caution.
‘The Shenzhen scheme’s success will depend on its real and perceived integrity,’ says Rubin. ‘The key to this is having clear and enforceable regulatory controls, diligence and serious requirements for listing and delisting, and reporting requirements. Investors will want to know that they can trust the market’. For that to happen, China must resist the temptation to intervene in its domestic capital markets when the going gets tough.
It willultimately come down to building investor confidence, which is a long-term, patient, step-by-step process. ‘This takes time and must be seen within the overall context of investor interest in and perceptions of China’s companies, its economy and the integrity of its capital markets,’ explains Rubin. ‘Regulators will need to strike a balance between liberalisation and controlling volatility, and investors need to feel comfortable with the applicable regulatory scheme and mechanics.’
Stephen Mulrenan is a freelance journalist based in Hong Kong. He can be contacted on email@example.com