Along with Shanghai-Hong Kong Stock Connect unveiled in November 2014, “Shenzhen Connect” marks the completion of Hong Kong’s mutual market access plans for China’s secondary equity market. Charles Li, Chief Executive of Hong Kong Exchanges and Clearing (HKEX), explains how it will give investors on both sides of the boundary more choices and enhanced access to each other’s markets

By Kenny Lau

The announcement in mid-August of the imminent launch of Shenzhen-Hong Kong Stock Connect – a stock-trading channel designed for foreign investors interested in “A” (domestic) shares of listed Chinese companies – is another landmark development in the establishment of mutual stock market access between Hong Kong as a major international financial center and China as a growing and important global securities market.

The official launch of “Shenzhen Connect” is expected to take place in the next four months, and it will mark the completion of Hong Kong’s mutual market access plans for China’s secondary equity market. Along with Shanghai-Hong Kong Stock Connect unveiled in November 2014, it affords Hong Kong unique access to China’s two stock exchanges in Shanghai and Shenzhen, further opens up China’s domestic stock markets to foreign capital, and connects Chinese investors to stocks traded in Hong Kong.

“Shenzhen Connect is the culmination of a lot of hard work and effort between regulators and the exchanges in Shenzhen and Hong Kong,” says Charles Li, Chief Executive of Hong Kong Exchanges and Clearing (HKEX). “It is also a major milestone in our mutual market initiative, giving investors on both sides of the boundary more choices and enhanced access to each other’s markets while playing a valuable role as a trusted partner in China’s financial liberalization drive.”

Mechanically, Shenzhen Connect is similar to the Shanghai Connect, and it will operate under a set of “Trading Links” for buyers and sellers in both Hong Kong and Mainland China. Trading in Shanghai (and soon in Shenzhen) is facilitated via HK-based brokers and a securities trading service company established by the Stock Exchange of Hong Kong (SEHK) in China; trading in Hong Kong is through appointed Mainland securities firms and a service company established by Shanghai Stock Exchange (and soon Shenzhen Stock Exchange) in Hong Kong.

Eligible shares  

Shares available for trading based in Hong Kong under Shenzhen Connect include constituent stocks of the Shenzhen Stock Exchange (SZSE) Component Index and SZSE Small/Mid Cap Innovation Index (with a market capitalization of no less than RMB6 billion), in addition to all of the A shares of SZSE-listed companies which also have H shares listed on SEHK in Hong Kong.

Conversely, all of the constituent stocks of the Hang Seng Composite LargeCap Index, Hang Seng Composite MidCap Index as well as any stock of the Hang Seng Composite SmallCap Index with a market capitalization of no less than HK$5 billion, plus all of SEHK-listed shares of companies which have issued both A shares and H shares, will be made available to Mainland investors.

“Shenzhen Connect provides more access, more flexibility, more products, and more opportunities. It gives international and Hong Kong investors access to more A share stocks and more sectors, such as technology and healthcare companies listed on the Shenzhen Exchange and ChiNext,” Li says. “With 880 new stocks included as part of the link, most companies traded in Mainland China can now be accessed directly by foreign investors for the first time.”

“Mainland investors now have more choice too, with 100 small cap stocks listed in Hong Kong now eligible for Shenzhen Connect,” he adds. “This, combined with Shenzhen Exchange’s marketing and investor education efforts, will likely bring new energy to Hong Kong over time.”

Under Shenzhen Connect, Mainland institutional investors and individual investors holding an aggregate balance of no less than RMB500,000 in their securities and cash accounts will be eligible to invest in the stock market of Hong Kong; and any Hong Kong or international investor will be able to trade stocks of Chinese companies; trading of shares listed on the ChiNext Board of SZSE, however, will be limited to institutional professional investors only at the early stage.

The reason for an initial restriction on investor participation in ChiNext stocks is largely “a prudent approach to Stock Connect all along to ensure that it succeeds as a stable, successful program,” Li explains. “The ChiNext board is a start-up board in Shenzhen with a number of small-cap companies that is high risk and high volatility. So we will initially provide access cautiously.”

“In fact, even the Mainland has restrictions in place vis-à-vis ChiNext. For example, Mainland investors who want to participate on ChiNext must sign a risk disclosure statement,” he says. “In time, it’s possible the Hong Kong securities regulator could introduce something similar here. But for now, retail investors who are interested in ChiNext stocks can trade them via institutions in Hong Kong, which creates new business opportunities for market practitioners in the city.”

“But like everything else in the mutual market access program that is designed to be manageable, sustainable and scalable, I expect this to evolve over time,” he adds. “Regulators will keep a close eye on how the scheme functions and individual investors [in Hong Kong] may be allowed to trade ChiNext shares eventually, subject to the resolution of related legal and regulatory issues.”

Investment quotas

Unlike Shanghai-Hong Kong Stock Connect when it was first launched, there will be no “aggregate” quota under Shenzhen-Hong Kong Stock Connect. In fact, the aggregate quota under Shanghai-Hong Kong Stock Connect has also been abolished with immediate effect on the day Shenzhen Connect was announced.

“Removing the aggregate quota should give institutional investors more confidence that the A share market is open for investment on a large scale,” Li says. “That means international investors can feel more comfortable investing in China and Mainland investors have more freedom and flexibility to invest in Hong Kong without fears of bumping up against a quota.”

There will, however, be a “daily” quota under Shenzhen Connect, and it will be the same as that of Shanghai Connect – RMB13 billion each in China’s stock markets and RMB10.5 billion each for demand from Shenzhen and Shanghai in the stock market of Hong Kong. The daily quote is subject to adjustment “in light of actual operational performance.”

“The daily quota will remain in place for risk management considerations, but [with Shenzhen Connect] it has effectively doubled,” Li points out. “That’s because the RMB10.5 billion quota currently in place for Shanghai Connect has been replicated for Shenzhen. That means Mainland investors have a total RMB21 billion quota to invest in Hong Kong stocks.”

“In fact, our experience with Shanghai Connect shows the RMB10.5 billion daily quota was only completely filled a couple of times in the nearly two years since it started,” he says. “Investors should therefore not be too concerned about the daily quota. It is just one extra safeguard in case there is an extreme flow of funds in either direction.”

Meanwhile, China Securities Regulatory Commission (CSRC) and Hong Kong Securities & Futures Commission (SFC) have also agreed to the inclusion of exchange-traded funds (ETFs) as eligible securities under the mutual market access schemes. Although no launch date has been announced, it is expected “to further enrich the variety of traded products and provide more investment opportunities and convenience for domestic and overseas investors.”

“The vast majority of A shares traded in the Mainland are now directly available via Stock Connect to Hong Kong and global investors,” Li says. “The inclusion of 200 ChiNext stocks also gives international investors access to more investment possibilities. The abolishment of the aggregate quota, expansion of access, and inclusion of ETFs sometime in the future prove Stock Connect is scalable and flexible.”

9 (with name)Market prospects

When Shanghai Connect was launched nearly two years ago, many speculated that the price difference between A shares in China and H shares in Hong Kong would narrow – which hasn’t been the case. The likelihood of an overall price convergence at the initial stage of Shenzhen Connect is also unlikely. “That’s because the investor makeup and sentiment in both markets are fundamentally different,” Li explains.

“The Mainland market is mostly made up of retail investors who can be fickle, while Hong Kong is dominated by institutional and value investors,” he notes. “The result is a pricing gap that will probably be sustained in the short term, while long term the pricing will likely converge as stocks become fungible and investors have more options.”

“However, I do think Shenzhen Connect is another step towards the internationalization of the Mainland’s A share market, and it’s only a matter of time before A shares are included in major global indices,” he adds. “Our job is to provide more access and more choices for investors to diversify their investments to the greatest extent possible.”

“The stocks listed in Shenzhen represent much of China’s new economy and the country’s future, so I anticipate interest from foreign investors in terms of diversifying their portfolios and having exposure to high-growth sectors.”

Regardless of initial market reaction to the launch, Shenzhen Connect is a long-term market facility that “can’t be judged in one day,” Li emphasizes. “Short term market fluctuations are based on the sentiment of the day, but increasing access to the Mainland market is something that will be sustained and enhanced over the long term. Mutual market access will have a far reaching impact on both markets.”

“We said at the very beginning of Shanghai Connect that the program could be expanded over time, and the decision to include ETFs is a great example,” he further notes. “There are a number of ways we can provide greater cross-boundary access for both Mainland and international investors, and we will continue looking at ways to broaden Stock Connect, include new asset classes, and build more bridges so investors will have more opportunities and more choices.”