What makes China’s equity markets unique?

Article by GlobalMacroForex

In the previous article, we discussed the potential reasons for the divergence of onshore Panda bonds and offshore Dim Sum bonds.  Now let’s go over a similar situation with China’s equity markets.

Since foreign currencies (like the USD) and onshore CNY can’t be exchanged with each other, it makes investing in mainland equities a challenge for foreigners.  To deal with this situation Chinese regulators have allowed 3 main types of equities — A-shares, B-shares, and H-shares. 

A-shares are dominated in onshore RMB and previously were available exclusively to Chinese residents.

B-shares, which are available to foreigners, are denominated in US dollars in Shanghai and in Hong Kong dollars in Shenzhen.

H-shares are for companies that list on the Hong Kong stock exchange.

A-shares typically trade at a premium to offshore shares and exhibit less volatility.  This may be reflected in the fact that since the capital account isn’t open, local Chinese have nowhere else to go than RMB denominated equities.  Another potential reason for the premium is offshore foreign investors have less access to information and are therefore more quickly willing to liquidate even on potential rumors to avoid being left in the dark.  A third reason is there’s overall less liquidity for foreign shares.   Foreigners only own 2% of China’s total market capitalization.  Since Chinese authorities have fragmented this market artificially with separate types of shares, it’s reduced liquidity in both.  These problems lead to the following new equity liberalization programs.

The first program is the Qualified Institutional Investor (QEII) program which allows screened foreign institutional investors access to mainland A-shares.  On May 2016, the maximum limit quota on this program was expanded to $81 billion, which is still relatively modest given the size of the market.

The next program is the Shanghai-Hong Kong Stock Connect program, which allows Hong Kong investors to access Shanghai A-shares.  Originally there was a quota of the maximum amount investors can collective buy/sell, but this quota limit was abolished/liberalized on August 2017.  

Even though the quota has been eliminated, the divergence in prices has only grown.  There was always a premium on A-shares over foreign shares (both B-shares and H-shares) even though it’s the same company being listed with the same cash flows.  One would think that the Connect program would allow investors to arbitrage away the price difference between the types of shares but it’s actually increased it.  The Hang Seng China AH Premium Index measures the price percentage difference of companies with shares on both the Hong Kong and Shanghai exchanges.  This chart from the Financial Times shows the index spiked as soon as the Connect program was initiated.

There are many ways to interpret what the reasons for this continued divergence.  A few potential reasons could include:

1)   Shares are denominated in different currencies.  Hong Kong dollars are essentially US Dollars via the Rate board.

2)  The shares have different liquidity profiles due to regulation

3)  Mainland retail Chinese investors may be unwilling to learn about foreign markets

4)  Since the CNY/CNH divergence takes places as the market takes an opinion on the future course of the country’s economy, this currency difference may also be reflected in the equity shares.

5)  Since the Mainland authorities tend to discourage onshore CNY to USD transfers for dividend payments, it may be working against companies to list in Hong Kong as it’s less liquid.  If companies decide between debt or equity, raising USD debt would be cheaper than RMB because of the interest rate differentials.  In contrast, selling Hong Kong dollar-denominated equity has no benefit if the offshore market doesn’t command a premium to onshore where investors can earn higher rates on unused current liquidity.  As the exchange rate shifts in unexpected ways, the company would be required to purchase CNY/USD (Hong Kong dollar pegs to USD) hedges to protect the earnings of its Hong Kong dollar investors.  This adds to the cost of equity if a company hedges.  And if a company does not hedge, then Chinese corporate managers are not really offering their full fiduciary duty to its Hong Kong dollar owners, which the market knows and is being reflected in a lower share price.

How to apply this

By monitoring the Hang Seng China AH Premium Index for the price difference, a Global Macro investor can understand the offshore vs. onshore opinion, which is a great forward leading indicator of the Chinese economy.  Onshore prices may less reflect fundamentals and more reflect government policy, or conversely offshore prices may be a better value play if one is a bull on the equity.