With the Shenzhen-Hong Kong Stock Connect slated to come online by the end of 2016, now is a good time to consider some of the major challenges in China’s most recent attempt to open markets to foreign investors. This moment of reflection is brought into sharper focus by China’s handling of the bursting of the stock market bubble a year ago. China’s initial attempt to open up the mainland stock markets, the Shanghai-Hong Kong Stock Connect, had a very high level of trading volume in early-mid 2015. But since then usage has dropped dramatically due to seeding concerns about China’s efforts to internationalize its markets.
The Shanghai – Hong Kong Stock Connect was announced by Chinese Premier Li Keqiang with much fanfare in April 2014. The purchase of class-A shares, denominated in RMB, had previously been limited to only a handful of selected foreign organizations that had obtained “Qualified Foreign Institutional Investor” (QFII) status. The wider opportunity to directly purchase Chinese shares was welcomed around the world. Any investor with a stock account in Hong Kong can now purchase selected class-A shares on the Shanghai Stock Exchange (SSE), and any mainland investor with over RMB 500,000 in an account can now purchase certain Hong Kong-listed shares.
The Connect got off to a rocky start in November 2014 when its opening was delayed by a month amid pro-democracy protests in Hong Kong and concerns that international investors were given insufficient notice regarding the tax and custody obligations involved. But once open, investments began to slowly increase both northbound – Hong Kong and international money flowing into the China markets – and southbound – Chinese money flowing into the Hong Kong market. By early 2015, average daily trading neared the fixed daily quota of RMB 10.5 billion for the southbound leg and RMB 13 billion for the northbound leg. But following China’s stock market turbulence in mid-2015 and again in January this year, trading volume has dropped. Since mid-2015, the monthly northbound average daily volume hasn’t even hit half of its quota.
Why has trade volume dropped significantly? Global investors have been scared off by the government’s handling of the stock crash and its aftermath. Margin trading, which grew at a fast pace in late 2014 and early 2015, along with encouragement from state media, contributed to the bubble burst in July, after a run that saw the key China stock indices more than double in just eight months. After a massive sell-off, Chinese regulators temporarily suspended trading of many shares and placed strict limits on the sale of shares by institutional investors, large investors, listed company executives and board members. In the first weeks of 2016, months after the initial crash, a newly-installed circuit breaker system, designed to halt trading if the market fell by a certain amount in a day, was triggered multiple times in just one week and was quickly scrapped. The Chinese authorities also invested a huge amount of money to prop up the market.
International investors rightly became wary of markets so prone to bubbles, manipulation and sudden restrictions of selling. While opening the markets to overseas investors is important, so are fair rules that all players understand. There were questions raised about the ability of the Chinese regulators to manage the markets and their willingness to relax their grip over the market. That led, amongst others things, to the decision by the Morgan Stanley Capital Index (MSCI) to yet again decline to include A-shares in its global indices.
Another concern for investors is the recent devaluation trend of the RMB which fuels the reluctance to hold too much capital in RMB-denominated assets. Chinese Premier Li Keqiang and PBOC Governor Zhou Xiaochuan have repeatedly stated over the past few months that China has the tools to avoid significant devaluation, but the RMB has dropped by more than 6 percent against the dollar since late 2015. Traders are troubled by the requirement that all trades involving the Connect are settled in RMB.
In the past year there have been signs of backsliding on the internationalization of Chinese markets. While investors may be eager to get their hands on class-A shares of tech stocks, likely available once the Shenzhen-Shanghai Connect comes online, this comes as international investors are increasingly wary of Chinese stock markets as a whole. Even if China continues to open equity markets to foreign capital, the lack of transparency and an unclear legal framework will continue to serve as barriers to investment.
China hopes to achieve market economy status from the WTO in December of this year. Providing foreign investors increased access to the Shenzhen and Shanghai stock exchanges could be important for China’s image as the EU and the United States decide whether to go ahead with affirming China’s market economy status.
Noah Shaw works at APCO’s Beijing office and supports APCO’s MNC clients in the ICT sector. Prior to joining APCO, Shaw worked at the Paulson Institute in their Chicago office. He has also interned at the U.S. Securities and Exchange Commission and the Beijing International Society.