Investing in China will soon get a lot easier — but likely no less risky. Today, the Shanghai Stock Exchange opens to the world’s retail investors and the Hong Kong Stock Exchange welcomed its first mainland mom-and-pop investors.
To limit the risks, Beijing and Hong Kong regulators have spent the past seven months writing detailed rules and running simulations for the two-way trading pilot program called Stock Connect, which officials said would launch today, about a month later than expected.
Get Ready for Stock Connect
Shanghai-Hong Kong Stock Connect is China’s latest step toward equities market liberalization. Until now, the Shanghai and Shenzhen exchanges have been closed to foreign retail investors and only partially open to institutional investors. Moreover, Beijing’s strict capital control laws have prevented most Chinese investors from trading stock overseas, including Hong Kong.
Stock Connect will not give the markets true free rein. Beijing regulators who took the lead in designing the program want to continue babysitting their domestic exchanges in part because they’re painfully familiar with the risks unique to Chinese equities.
Regulators know, for example, about the market’s long struggle with insider trading, called “rat trading” in China. They’re also mindful of how hot-money inflows, shadow banking and corporate corruption have affected the economy in recent years, often sinking stock values along the way.
So non-Chinese retail investors who have never heard of rat trading but still want to invest in the 568 Shanghai A-shares accessible through the program — stock in companies from big names like PetroChina (PTR) to obscure firms such as Pudong Jinqiao — had better do their homework.
For starters, foreign investors should clearly understand that the program’s thick rulebook is first and foremost designed to protect Chinese retail investors who already play Shanghai stocks, and the state-run companies that dominate the country’s stock exchanges. About 1,000 companies trade in Shanghai and 1,600 in Hong Kong.
Read the Rulebook
Under the program’s quota rules, for example, all buyers and sellers on a given day will be allowed to put no more than a combined $2.1 billion into Chinese shares. The daily quota for Hong Kong-bound trades in 268 eligible companies is about $1.7 billion. All trades must be settled in yuan, China’s currency. Day trading is not allowed.
Most non-Chinese investors will have to buy yuan and open brokerage accounts in Hong Kong before they can start trading Shanghai stocks. In so doing, they should consider currency exchange risks, since the Chinese government closely manages the yuan. Although the U.S. Treasury has never accused the Beijing government of being a currency “manipulator,” it has pointed in that direction by calling the yuan undervalued.
The Chinese government’s use of tax, customs, public infrastructure projects, state banks and various policy measures to manage the economy is another reason investors should be cautious about direct investing in Shanghai stocks, according to recent UBS Securities analysis. “Economic and policy surprises pose the most consistent and continued risks,” said one UBS report. “Economic growth can be volatile, leading to earnings uncertainty. Inflation volatility can likewise lead to interest rate uncertainty.”
A separate UBS report said Shanghai stocks today face “medium-term downside risks” tied to China’s slumping real estate market and “the manufacturing sector’s willingness to invest.”
About half of the Shanghai-listed companies available for trading are heavy-industry manufacturers, companies in the mining and mineral resource business and financial services firms including major state banks. The rest are utilities, energy, consumer-related, telecom, healthcare and computer services stocks.
Mind the Gap
Investors will also want to watch how, as many analysts expect, the two-way trading gradually closes any gaps in stock values for companies with shares that trade in Shanghai as well as Hong Kong. In particular, current holders of Hong Kong shares in these dual-listed companies could see their values fall after the program launches and investors shift to what are now less expensive Shanghai shares.
Finally, no discussion of the risks of investing in Chinese stocks would be complete without mentioning corporate governance. When discussing Stock Connect opportunities recently with clients considering Shanghai companies, brokers have been careful to note that accounting and financial reporting practices on the mainland, particularly among state-run firms, do not always follow western conventions.
As of this writing, Eric Johnson did not hold a position in any of the aforementioned securities.