AS GREATER CHINA’S two biggest stock exchanges prepare to go live with a long-awaited cross-border stock link-up, the CEO of every major global bourse must be lining up to sign a similar agreement with Shanghai.
Market participants tout the Shanghai-Hong Kong Stock Connect pilot scheme as a key moment in the opening of China’s capital markets. For an executive at a foreign bourse, making your exchange more hospitable to Chinese capital has got to be high on the to-do list.
Despite the initial overseas enthusiasm, however, it is Chinese buyers that stand to benefit the most. International investors, in the meantime, will be the ones taking on the greater risks.
Investing overseas would give Chinese investors exposure to new companies and higher corporate governance standards. The same isn’t true in the other direction.
Traders expect flows into Shanghai to dwarf outflows in the early days, and northbound quotas from Hong Kong could even be tested from day one as international investors in the SAR go in search of arbitrage opportunities in the A-share market.
Should PRC regulators decide to bring the so-called “through train” to New York, it is easy see a Chinese investor jumping at the chance to buy into Nasdaq-listed Baidu, the country’s ubiquitous search engine. The first opportunity to buy shares in Facebook or Twitter might also be too good to pass up – even if their products are largely blocked on the mainland.
There may well be compelling value opportunities for overseas buyers, too. Foreign investors, however, will need to be willing to overlook additional risks if they are to invest directly in the onshore equity market – especially in the area of corporate governance.
At present, overseas fund managers are spending much time worrying about the Hong Kong-Shanghai scheme’s weaknesses, including uncertainties over taxation and settlement. Yet they have given the issue of China’s poor corporate governance short shrift.
Investors’ exposure to China’s irregular corporate-governance standards is only going to get bigger
THAT MAY BE typical behaviour when it comes to investing in overseas-listed China stocks, but mainland shares and mainland regulations are very different.
The China Securities Regulatory Commission has been trying to restore confidence in the country’s equity markets following a series of recent scandals, even freezing new issues for a year while it audited disclosure standards among the hundreds of IPO candidates. However, many of the more tempting stocks for overseas investors were listed well before the regulator launched its latest batch of rules, and questions linger over local reporting standards.
The ongoing corruption crackdown at some of China’s biggest companies notwithstanding, corporate governance is hardly the strongest suit of the world’s second biggest economy.
From the outset both cities’ regulators have made sure that buying will be funnelled to the “better” stocks.
Southbound buyers can choose from stocks in the Hang Seng Composite LargeCap and Hang Seng Composite MidCap indices. Northbound investors can buy constituents of the SSE 180 and SSE 380 indices. Also thrown into the mix are shares listed on both bourses.
Investors are already trying to wager on just how those buying limitations will affect share prices. Since the initiative was announced on April 10, the Hang Seng Index has traded up nearly 10% and the SSE 180 Index nearly 4%.
However, as the through train gathers momentum, regulators will relax those investment restrictions. Foreign equity investors will have access to a larger pool of onshore stocks.
Foreign bond investors – higher up in the capital structure than their equity counterparts – have welcomed record volumes of overseas Chinese debt in the last three years, but even they think twice before investing in onshore PRC debt.
Offshore yields are more attractive, and onshore risks unknown. Portfolio managers everywhere are still trying to make sense of the first default in China’s domestic bond market, from Shanghai Chaori Solar Energy Science and Technology, earlier this year.
Bond investors understand that investing offshore gives them little access to Chinese companies’ onshore assets when things turn sour. Shareholders, in those cases, usually fair much worse than bondholders. There have been plenty of reminders over the years, from Guangdong International Trust & Investment Corp to Asia Aluminum and, most recently, Sino-Forest.
Issuers sometimes offer a parent guarantee or standby letter of credit to placate investors, as on this month’s US$500m bond for China Metallurgical Group.
BUT EQUITY INVESTORS in the cross-border scheme will get no such guarantees. They won’t even technically own the stocks whose risks they assume. That should be cause for alarm. The specialist China investors who are expected to drive the volume in the pilot programme may have already worked out the amount of risk they are willing to take.
Yet, as Shanghai links up with other Western markets, investors’ exposure to China’s irregular corporate-governance standards is only going to get bigger.
Market expectations that MSCI is going to start to include A-shares in its all-important emerging-markets index as soon as next year also means that more money managers will have to consider what Shanghai has to offer if they want to match the benchmark. MSCI said in June that it was closely watching the development of the cross-border stock initiative as it considered whether to include renminbi shares.
Investors, however, shouldn’t be waiting until the stock scheme is extended beyond Hong Kong to start taking the issue of corporate governance seriously. Northbound investors buying into the Shanghai Stock Exchange for the first time should make it their number one priority. How exactly they do this, of course, is up to them.
Some hopeful market participants might rationalise their optimism with this blue-sky scenario: the best practices of the West will rub off on Shanghai dealmakers and the corporate governance standards will, after some time, significantly improve. That may well happen over time, but anyone expecting it to happen overnight is misguided.
Perhaps that is why many expect the biggest beneficiaries of any cross-border plan are going to be Chinese retail investors, whose investment options will grow considerably. You just may not be able read about their best stock picks on Twitter.
