Shenzhen-Hong Kong Stock Connect: what you need to know

China Stock Market Slide

It will be another four months before the much-anticipated Shenzhen Hong Kong stock connect system finally goes online and provides another bridge between the mainland and the offshore stock markets.

The stock exchanges in Shenzhen and Hong Kong jointly made an announcement yesterday, providing investors with some details of how the system is going to work.

Here we answer some questions based on information released by the two stock exchanges about what the Shenzhen stock connect means for China and for ordinary investors, how it would be regulated, and why you may want to pay attention.

There already is a stock link between Hong Kong and them mainland market in Shanghai. Why do we need one with Shenzhen?

The first stock connect program linking Shanghai to the offshore market in Hong Kong gives foreign investors access to only a fraction of the nearly 3,000 stocks listed on mainland markets.

Besides, the Shanghai Stock Exchange is dominated by state-controlled industry giants such as Sinopec and financial institutions such as the big four banks. Many public companies specializing in information technology or consumer goods and services are listed in Shenzhen, especially on its board for small- and medium-sized enterprises and ChiNext, a Nasdaq-style board for hi-tech enterprises. These sectors are expected to grow faster than traditional industries as China pushes structural reforms to its economy. So, foreign investors betting on China moving away from heavy industries and toward greater domestic consumption may want access to the Shenzhen market.

Also, the Chinese government is pushing this second link because it wants to attract more foreign capital. It wants to prove to international investors that it is making progress towards removing barriers for them to tap China’s US$ 6.5 trillion equity market. Concerns about a lack of access – as well as regulatory restrictions that make trading and proceeds repatriation difficult – have prevented the MSCI from including the Chinese stock market in its widely tracked emerging-market index, to the frustration of the Chinese government.

Will the Shenzhen stock connect include more options for investors to choose from than its Shanghai sibling?

Yes, but we don’t know yet exactly how many stocks will be included in the system. The announcement specified that the number of stocks to be included in the Shenzhen stock connect will be linked to how many Shenzhen-listed firms have a market value of at least 6 billion yuan (US$ 905 million) and how many firms listed in Hong Kong have a market valuation of at least HK$ 5 billion (US$ 645 million).

Based on the closing stock prices on August 16, foreign investors will have access to more than 860 stocks in Shenzhen, compared with about 570 in Shanghai through the existing link. The number of stocks mainland investors will be able to buy in Hong Kong is expected to increase by more than 100 to reach about 420.

The numbers will be more precise once Shenzhen and Hong Kong stock exchanges clarify how they will calculate corporate market valuations.

Will this new stock link program lift share prices?

The new stock connect means a potential boost to both markets because it could increase the amount of capital available for investment on both sides. But analysts say any potential increase in capital on either side is likely to be trivial and not noticeable, at least in the short term.

Research by Guotai Junan Securities, for example, estimates the new link could channel up to 150 billion yuan from Hong Kong to the Shenzhen Stock Exchange in the first six months after its launch, based on the firm’s analysis of trading activity through the similar Shanghai Hong Kong stock connect. That’s less than 2 percent of the combined value of publicly traded stocks that make up the Shenzhen Component Index.

Who can buy stocks through the new stock connect system?

As is the case with the Shanghai Hong Kong stock connect, mainland individual investors will need at least half a million yuan in their securities trading account to buy Hong Kong-listed stocks.

Restrictions are imposed on the offshore end of the system so only institutional investors in Hong Kong can buy stocks listed on the ChiNext board. This rule will be changed to broaden access to all other investors, according to the joint announcement. But it did not say when.

Is there any trading quota?

Yes, but only on daily net purchases. The Shenzhen stock connect will keep the same daily trading limits as those for the Shanghai system – 13 billion yuan on investment from Hong Kong to Shenzhen and 10.5 billion yuan the other way round. Shanghai and Hong Kong stock exchanges can adjust the quotas based on operating conditions.

There will not be any limit on the accumulated amount of investments that can be made in either direction. The Shanghai Hong Kong stock connect was subject to an aggregate quota of 250 billion yuan on the southbound channel and a quota of 300 billion yuan on the northbound one. The restrictions were abolished on August 16.

Anything else I should know?

The average price-to-earnings ratio on the Shenzhen Stock Exchange seems way too high compared with those in many more mature stock exchanges, including the one in Hong Kong.

This can mean great investment opportunities – or a cause for concern – depending on where you are and how much risk you can take.

There is often a big divergence between the valuations of similar listed companies between the Shenzhen and Hong Kong markets, a phenomenon that is often attributed to the fact that the Chinese stock market has more retail investors, who lack investment expertise and are driven easily by emotions.

More importantly, the Chinese securities regulator keeps tight control on which companies can go public, thereby resulting in a mismatch between supply and demand in the equity market that leads to corporate overvaluations.

Arbitrage investors can make money by exploiting the divergence in valuations. But it’s worth keeping in mind that volatility in the Shenzhen market has been great. The Shenzhen Component Index, a main stock price indicator, for example, fell by about 30 percent in the first two months of this year.