At least the Shanghai-Hong Kong Stock Connect functioned as it was designed to do during its first week of trading. Yet, whilst the first day of trading was busy, volumes immediately plummeted, throwing the six months of effort and expense incurred during its preparation into sharp relief.
Hong Kong Exchanges (HKEx) attempted to put a brave face on it, pointing to the fact that at least the bridge worked properly, but there is a sense of foreboding that the Stock Connect is going to endure as just another under-used, cross-border access system in Asia. In that case, until China’s capital account is opened in full and markets are fully thrown open, we may never know the true international latent demand for investment.
Net investment for the Stock Connect’s debut week was 26.6 billion yuan ($4.34 billion), or 23% of the quota.
Most of this was Northbound investment, which traded a disappointing 23.6 billion yuan over the first five days of operation to reach 36% of its quota limit.
Southbound trade from Shanghai to Hong Kong was even less enthusiastic, with 2.9 billion yuan traded over the first week, or just 6% of the quota.
The real risks of Stock Connect lie in the custody requirements and poor levels of corporate governance in the Chinese stock market, according to Philippa Allen, CEO of consultancy group ComplianceAsia.
“For asset managers, the custody issue is a huge one,” said Allen. “You have to put your custody into a HKEx entity in China and potentially lose the trail of custody, which is a big issue for international fund managers.”
“Fundamentally though I think the biggest problem is that the A-share market it self is actually inherently a non-compliant market,” she added. “There’s too much insider information, too much corruption, there’s no sense of governance…and there will be some firms that choose not to be involved with it.”
Poor Southbound demand may be attributed in part to the large number of shares that are listed on both the Hong Kong and the Shanghai exchanges, but Allen said hesitance on the Chinese side may also be due to the lack of attention paid to Chinese investor trading preferences.
“One of the problems in China is that Chinese investors don’t like the T+2 settlement cycle in Hong Kong,” she said. “They are on a shorter settlement cycle, so when they are told they are not going to get their money back for two days, they can’t understand the delay.”
“Getting them comfortable with the fact that there’s no counter-party risk and that the trades so actually settle and that they do receive their money back has also proved challenging, so it has apparently been quite a tricky sell in China,” Allen added.
For Northbound trading, Allen said the issues with inside information and governance among companies in the domestic Chinese market may not prove a problem for experienced fund managers, as many have traded A-shares using the Qualified Foreign Institutional Investor (QFII) scheme. But she said large mutual funds and asset managers with strict investment requirements will most likely sit out the first few months of trading to see how the risks unfold.
“When you’ve got the big international asset managers kind of waiting on the side-lines because they want to figure out how it works, you then run the risk that there is a whole stack of less institutionalised money that moves into it,” Allen said.
“So I think you’re going to see some volatility in it, I think there’s going to be an element of risk because of the nature of the money that’s going to enter it to start with.”
Despite these structural problems and their impact on Stock Connect, Allen was positive about the long term future of governance in the domestic Chinese market, saying that local regulators had shown their determination to solve many problems with the Chinese exchanges, although she acknowledged that this is “not going to happen overnight.”
“The regulators in China are very good. They really do know what they are talking about and they understand how things work in the rest of the world,” she said. “They are struggling with a big market place, they are struggling with enforcement, but the laws they issue actually pretty good and I don’t think we give them enough credit for how far they have come in a really short period of time.”