Investors cheering China's market expansion should be careful what they wish for

A new pilot scheme could give investors greater access to China’s vast equity market. But the project may also affect the performance of existing Hong Kong-listed shares, says Will Ballard.

3 minute read

Stormy seas ahead

For equity investors clamouring for more access to the Chinese market, 2018 opened with some good news. The China Securities Regulatory Commission (CSRC) has confirmed a pilot scheme under which three mainland companies will be allowed to release some of their non-tradeable H shares into circulation on the Hong Kong Stock Exchange.1

While the announcement was made with little fanfare, it could have some major implications for the Chinese equity market. If the scheme is successful it could be rolled out to other mainland firms listed in Hong Kong, many of which currently have a significant portion of their share capital locked up due to strict regulation. According to UBS research, 154 Chinese companies are sitting on non-tradeable H shares worth a collective HK$2.6 trillion ($332 billion).

Time will tell whether the CSRC will sanction the free release of all of these H shares given the regulator’s traditional reluctance to relax control of cross-border capital flows. Nevertheless, the scheme looks promising. Freeing up mainland companies’ share capital should boost liquidity and bring about a greater alignment between controlling parties and public investors, among other benefits. But any expansion of the Chinese equity market could also affect the performance of shares that are already listed.

China’s market reforms

Before considering these potential consequences, it’s worth exploring the thinking behind the CSRC pilot scheme, which should be understood in the context of China’s wider market reform efforts. In the absence of mature bond and equity markets, Chinese companies rely heavily on bank loans and the authorities are keen to open up different sources of funding.

This was the motivation behind the government’s attempts to expand and liberalise the country’s equity market in 2015, although it will be hopeful of a better outcome this time around. The 2015 process was badly handled, and the ensuing sell-off sent shockwaves through global markets.

The CSRC pilot scheme is a more modest initiative but the objective is the same as it was three years ago: to give Chinese firms more freedom to tap equity and bond markets for longer-term, more-sustainable funding.

As President Xi Jinping indicated during the 19th Party Plenum in October 2017, the government is also keen to reform China’s state-owned enterprises (SOEs). Xi’s administration recognises the preponderance of unwieldy and uncompetitive SOEs is hampering the transfer of capital and resources to more productive sectors and ultimately undermining economic stability. Enabling SOEs to issue more H-shares could help by broadening these companies’ ownership bases and encouraging a greater focus on investment returns and efficiency.

Expanding the market

Yet while the CSRC pilot scheme could bring some benefits for investors and policymakers, it may also impact performance. To understand why, you need to look at the dynamics of market expansion.

Equity markets can grow in one of two ways. First, the constituent companies can rise in value, lifting the market capitalisation of the whole index. This is what has occurred during the bull market in US equities over the last few years. So-called ‘de-equitisation’ played a role; due to the widespread practice of equity buy-backs, de-listings and take-overs, the number of free-float adjusted shares outstanding on the MSCI North America Index has declined to its lowest level since 2010. As the number of listed shares declines, the price of those that remain tends to go up.

The other way for a market to grow is through the issuance of new shares. This is more common in fast-growing emerging economies. Take Turkey, for example. The Turkish market is likely to see about $4-4.5 billion in equity issuance this year, comprising both initial public offerings (IPOs) and new issuance from already-listed companies, many of which are looking to convert euro-denominated debt into equity in order to refinance it.

The problem is that only $3-3.5 billion of new investor capital entered the Turkish equity market last year. Unless that figure rises sharply in 2018, investors will likely need to sell stocks they already own to buy the new issuance, which could impact share prices and lead to poor relative performance across the market.

Headwinds to performance

This is the risk investors in China should be mindful of as the CSRC pilot scheme progresses. The share count of the Chinese market is already increasing at a meteoric rate (see figure 1), feeding a constant demand for liquidity simply to support the overall index level.

Figure 1. Share count in MSCI North America vs MSCI China
Source: Bloomberg, December 2017

Figure 2 shows how the share count on the Hang Seng China Enterprises Index (HSEI), which tracks mainland companies listed in Hong Kong, has increased over the last decade. The dotted line indicates the extent to which the share count could rise still further, were the full amount of H-shares to be unlocked.

Figure 2. HSCEI share count and index performance
Source: Bloomberg, December 2017

In periods of rapid market appreciation, a 10-15 per cent increase in the total number of shares outstanding would probably not have a drastic effect on overall market price appreciation, and a drastic sell-off seems unlikely.  However, should 2018 prove to be a weaker year for the Chinese equity market than 2017, this type of additional supply could be an additional headwind to performance.

All this considered, market participants keen for more H-shares to invest in should be wary of how their existing portfolio might be affected should the floodgates open in Hong Kong.


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