The Hong Kong-Shanghai Stock Connect programme will extend to Shenzhen in November, and potentially to bonds at a later date. International investors are intrigued, yet sceptical.


The Chinese Through Train is close to arrival at its second destination. International passengers are likely to remain on the platform again.

Stock Connect, launched in late 2014 and colloquially known as the Through Train, gave investors in Hong Kong and Shanghai mutual access to companies on the other market. The authorities hoped it would encourage more international and stable investors into onshore Chinese bourses. By allowing this, domestic markets, which can swing in reaction to the short-termism of retail investors, could focus more on company fundamentals, like governance, dividends and value.

The scheme will extend to the south eastern Chinese city of Shenzhen in November. The three exchanges are also in discussions to extend the trading link to the onshore bond market. Eventually, the expanded network could help Chinese equities and debt gain entry into international benchmarks, which would embed Chinese securities into global portfolios.

There is much work to be done before these ambitions can be realized, however. Indeed, Chinese stocks failed to gain access to MSCI benchmark indices for a third time in June. Referencing the decision, the index compiler said international institutional investors had expressed the need for further improvements in access to the A-share market before admission.1

“There has been surprisingly little interest from international investors ahead of the launch of the Shenzhen Stock Connect,” said Will Ballard, head of emerging market and Asia-Pacific equities at Aviva Investors. “And its fair to say that foreign take-up of the Shanghai Connect concept has not been as ubiquitous as the authorities had hoped.”

In the early days of Shanghai Connect, all appeared well. A week after its launch on  November 14, 2014, figures from the Hong Kong Exchange showed 88,631 northbound trades into Shanghai, equivalent to a turnover of RMB 2.662billion  (US$399.2 million). Domestic southbound trades into Hong Kong numbered 10,794 for a turnover of HKD 443 million2.

The gyrations of Chinese markets in the last two years and artless intervention by regulators are part of the reason why international investors turned cool. Between the end of 2014 and June 2015, a sizeable bubble inflated and popped in China’s domestic stock market.

Further turmoil followed in January 2016. Market perception outpaced economic reality to create one of the bleakest ever starts to a year for Chinese equities. Investors went into panic about fading growth, which was neither unexpected nor alarming, on the back of downbeat manufacturing data. Regulators responded with policy blunders - in particular a tighter pricing band on the circuit breaker - which in turn fuelled further panic.

Ballard cites the complex structure of the Connect programme as a further reason for foreign investors’ ambivalence.

“What we have is a fudge designed to give investors controlled access. Having to use a complicated mechanism to access domestic Chinese stocks through Hong Kong is dysfunctional. Investors want full direct access, like they have in most other parts of the world,” he said.

To be sure, Zhou Xiaochuan, Governor of the People’s Bank of China (PBoC), said the country was not looking to emulate the traditional concept of a fully open capital account. Speaking in April 2015 at the meeting of the International Monetary and Financial Committee, he said China was drawing lessons from the 2008 global financial crisis. “China will adopt a concept of managed convertibility,” Zhou said3.

The ambiguous approach was in evidence when Charles Li, Chief Executive of the Hong Kong Stock Exchange, said in August that aggregate trading quotas would be abolished with respect to the Shanghai and Shenzhen schemes4. Daily quotas were to remain in place, however, as a safeguard against an extreme flow of funds in either direction.

All of which begs the question, what are the attractions of the Stock Connect?

For some, the combined market is too big to ignore. Goldman Sachs Research argues that integration of the Chinese A share market and Hong Kong creates the world’s second largest equity market; the third largest market in terms of cash trading5.

For others, diversification is the main advantage. Shanghai is dominated by banks, property companies and state-owned enterprises; so-called old industry. Shenzhen is more focused on privately-run companies and offers investors access to businesses that stand to grow as China rebalances towards a consumption-led economy. Healthcare, consumer discretionary and technology companies feature prominently on Shenzhen.

Shenzhen Connect also means individual investor quotas under the Qualified Foreign Institutional Investor scheme (QFII) and Renminbi Qualified Foreign Institutional Investor scheme (RQFII) can be put to use elsewhere. Shenzhen Connect can be the channel for investing in large companies, freeing up QFII and RQFII quotas for small and mid-cap high growth stocks, Ballard said.

The trouble with bonds

Transforming the Hong Kong, Shanghai and Shenzhen exchanges into a relevant centre for fixed-income could be a harder challenge than opening up the equities market. CEO Li acknowledged that, as an off-exchange initiative, Bond Connect would be a new direction in fixed-income for the Hong Kong Exchange.

Foreign investors already have direct access to Chinese onshore bonds through the interbank market following PBoC reforms earlier this year. Jethro Goodchild, Asian-based fixed-income manager at Aviva investors, estimated that around 90% of onshore trading occurs in the interbank market, compared to around 10% over the exchange channel.

“The exchange providers are an alternative platform for bond trading and eventually want to compete for foreign capital via the Connect,” said Goodchild. “If they were to open up the Shenzen Connect now for bonds, the initial response would be muted. Most of the liquidity remains in the interbank bond market, at least for now.” He added that, with regard to the on-shore corporate bond market, foreign investors were more concerned about the efficient pricing of credit and default risk rather than how to access the market.

China’s total debt-to-GDP is around 230 percent, the highest for any emerging market, as estimated by the Bank of International Settlements. According to the IMF, about 160 per cent of the debt is corporate sector debt. Investors are wary of stepping in because they fear treading on defaults. A rise in defaults among private and state-owned enterprises (SOEs) has already led to widening credit spreads. Corporate defaults number around 20, with more expected.

“China has not had a proper credit cycle, so international investors have focused mainly on government and quasi-government debt. The bankruptcy regime is also untested and there is a lack of comfort due to the absence of international ratings,” Goodchild added.

China updated its bankruptcy law in 2007, although it is used infrequently and has never been applied to a bond default. In developed markets, noteholders can ask a bankruptcy court to order a debt restructuring or liquidation to recover payment through asset sales. Chinese investors have found themselves mired in bureaucracy and long-standing out of court negotiations. Chinese courts may also want to avoid putting a company into bankruptcy because of the potential social and political fallout linked to restructuring of state-owned businesses.

While China’s focus on controlled access to onshore markets is frustrating, investors see value in the Connect schemes over the mid to longer-term. For Ballard, the prospect of domestic equities investors gaining access to an extended universe of smaller Hong Kong companies is compelling. Goodchild notes that further opening of the bond market in any form is a huge step in principle because China is the world’s second largest economy and the third largest bond market.

In a contrarian twist, Goodchild muses that a Chinese model of centralised bond trading via an exchange platform might influence thinking in developed markets. “It could be viewed as a better alternative to the western model, where investment banks are still holding a monopoly over the price discovery mechanism.  As they step back it is a significant drain on liquidity,” he said.








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Unless stated otherwise, any sources and opinions expressed are those of Aviva Investors Global Services Limited (Aviva Investors) as at 4 October 2016. This commentary is not an investment recommendation and should not be viewed as such. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. Past performance is not a guide to future returns. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested.

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