All aboard China’s reform train

Shanghai-Hong Kong Stock Connect is a significant step in the opening up of China’s capital account

was surprised to hear the positive news first hand from China’s Premier Li Keqiang at the recent Boao Forum that investors in China and in Hong Kong will soon be able to trade shares on each other’s exchanges.

Coming from the Premier himself, the announcement underscores Beijing’s strong determination for reform.

Shanghai-Hong Kong Stock Connect – or more commonly known as the ‘Through Train Programme’ – is set to be launched in six months, and is a significant step in the opening up of China’s capital account.

Enabling cross-border two-way capital flows, the programme is a long-awaited, missing ingredient in the internationalisation of the renminbi. Up to this point, the liberalisation of China’s currency has primarily been focused on the economy’s current account and in particular on trade and direct investments.

Since last year’s change in leadership, there has been a noticeable step-up in the pace of reform. This latest Shanghai-Hong Kong linkage is amongst a plethora of new measures rolled out by the Chinese government at a breathtaking pace.

In the past few months alone, we have seen a widening of the renminbi trading band, the end to the People’s Bank of China’s control on bank lending rates and the launch of Shanghai’s Pilot Free Trade Zone, which opens up two-way corporate payment flows.


Provides sought-after access to Chinese assets

The Through Train Programme is also a first step to quench the thirst of investors for Chinese assets, which have hitherto been inaccessible. Hong Kong, the leading renminbi offshore centre, will soon become the choice bridge between, on one side, global investors, who will gain direct access to China’s stock market and, on the other, tens of millions of mainland savers keen to diversify their assets.

The Through Train Programme allows mainland Chinese investors to trade Hong Kong shares up to a quota of CNY250 billion, and Hong Kong investors to trade in Shanghai-listed shares up to CNY300 billion.

Up to now, access to China’s A-share market has been limited to licensed institutional investors going through the QFII/RQFII quota schemes. The new programme provides a more direct and flexible means for investors, including retail investors, to trade Shanghai-listed shares without the need for going through fund managers.

Like most reforms, every change will bring about knock-on effects. As a start, the programme may narrow valuation gaps between the Shanghai and Hong Kong equity markets. The CNY20,000 conversion cap may become the next regulatory consideration in China’s pipeline. Listing in Hong Kong may present a fresh appeal to foreign issuers. And given the scheme is denominated in renminbi, the implicit convertibility of the yuan has never been clearer. These are all plausible suppositions to bear in mind.

Skeptics may argue that the quotas set by China limit the scale and relevance of the Through Train Programme. But it is important to note that the quotas are net amounts, not gross, and that underlying trading value can be many times greater.

For policy makers, it is more straightforward to bring about changes when a market is either all open or closed. It is a different matter when a market is trying to move from one to the other, where far more considerations need to be taken.


Chinese policy changes can have major implications

It is true that by imposing quotas, China has stopped short of a complete opening of its capital account. Yet, quotas are absolutely necessary to manage the transition from a closed economy to an open one – not to mention this is an economy worth CNY57 trillion and second in size only to the US. Even the smallest degree of change in China’s policy could have tectonic-shift implications for the mainland, and send ripple effects across global markets.

China always moves one step at a time, starting new programmes small and expanding them in an orderly manner only when the time is right. To be successful, the Through Train Programme will need expanding and it may prove difficult to achieve the desired results without going all the way.

The opening of stock trading will bring about a different approach to qualified foreign and domestic institutional investor schemes. The former offers a new avenue to directly invest in China and Hong Kong stocks, whilst the latter still has its intrinsic portfolio value as it spans across a wider spectrum of investment alternatives including bonds and futures.

Also on the horizon is the introduction of a ‘mutual recognition’ programme which allows Hong Kong-based mutual funds to raise money from mainland investors and vice versa. All these are progressive examples of China’s willingness to experiment with different policy variations in the journey to open up its economy.


There will be bumps along the way

The Through Train Programme is not perfect. There will be questions and concerns over the quota application and what happens when quotas are reached. Inevitably, any quota system will create distortions and may induce unnecessary problems.

Investors should brace themselves for bumps along the way, but they should not be put off participating in this significant step in China’s market liberalisation. What lies ahead will be well worth the ride.

A version of this article appeared in the South China Morning Post on 15 April 2014