Shanghai Hong Kong Stock Connect setting China up as a trading rival to US

The world's third-largest stock exchange with US$5.6tn market capitalisation, giving investors unprecedented access to the world's largest consumer market? It could happen, thanks to Shanghai-Hong Kong Stock Connect.

Amid the hustle and bustle of the 26th APEC Summit in Beijing, the Chinese government finally granted the green light to a long-awaited plan to connect the Hong Kong and Shanghai stock exchanges.

The Shanghai-Hong Kong Stock Connect opened this week, allowinig a daily quota of US$3.8bn in cross-border purchases by investors operating through both exchanges.

Before this, only a handful of fund managers were allow to trade Shanghai 'A' shares under a quota system capped at a total of US$105bn. Since Hong Kong’s capital markets are opened to any foreign investor with a local brokerage account, the average retail investor around the world can now buy into any of the 568 companies listed in the Shanghai Stock Exchange with the linkage.

For foreign investors, access to Shanghai 'A' shares also means buying into the potential success of a China economic revival, with the Chinese government vowing to boost the domestic consumption of its 1.355bn population to reduce dependence on exports and infrastructure spending.

Likewise, Chinese investors will be able to access the 'H' shares listed on the well-respected Hong Kong Stock Exchange (which operates under stringent and transparent regulations) for the first time. This is likely to boost Chinese households’ confidence in equity investment and influence their asset allocation decisions. It would encourage them to re-allocate their financial assets from cash deposits to equity investments in the Hong Kong market.

By international standards, Chinese mainland households are still deeply under-invested in the equity market; only 12% of their US$10.6tn financial assets are invested in securities with 64% sitting in cash deposits with negative yields in real terms. On the contrary, US households park 44% of their financial assets in securities with only 16% in deposits.

Since the announcement of the exchange connection in April, the Shanghai Composite has risen 14.8% while the Hang Seng Index has gained 3.1% with the main beneficiary being the city’s stock exchange operator (Hong Kong Exchanges and Clearing Limited) which soared to 34.1%. According to BNP Paribas, the linkage could boost the average daily value of stock trading in Hong Kong by about 38% by 2015.

The exchange link is a significant step in China’s ongoing financial and economic reforms. It looks to accelerate capital account liberalisation, promote international use of its tightly controlled renminbi and elevate Shanghai’s position as a global financial hub. The collaborative mechanism will likely drive up the value and volume of both markets while enhancing competitiveness and efficiency. The linkage may eventually lead to the creation of the world's third largest stock exchange (after the New York Stock Exchange and NASDAQ OMX) with US$5.6tn single market capitalization, overtaking Tokyo and London.

But it’s not all about China. The position of Hong Kong as an offshore renminbi centre will be strengthened by the linkage as it allows their mainland counterpart to invest directly in the local stock market using renminbi. US.-based brokers Jefferies Group went as far as telling its clients that the linkage is putting Hong Kong "at the forefront of the largest capital account opening of a country since WWII". This development reaffirmed Hong Kong’s position as the facilitator of China’s financial integration with the global market as the mainland financial markets are not mature enough for full liberalisation.

While the linkage might be a milestone in China’s financial liberation, differences of regulatory environments in both markets require further consolidation when it comes to actual execution. For example, the imposition of 10% capital gains tax on non-resident equity investors in China is not applicable in Hong Kong.

Also, Chinese investors are required to hold the stocks in their accounts on the trading day but its Hong Kong counterparts only need to transfer the stocks two days after they sell.

The Shanghai-Hong Kong Stock Connect is only the first step in integrating China's major stock exchange with the global market. Hong Kong Exchanges and Clearing Limited's CEO Charles Li hinted that a linkage with China’s second largest stock exchange, the Shenzhen Stock Exchange, is in the pipeline. If the linkage were expanded to Shenzhen, China’s combined exchanges would form the biggest stock market in the world outside of the US.

China might be losing its edge as the “world's factory floor” but it could be well on its way to become the “world's trading floor”.