Equity 'indexation effect' tipped to benefit HK market

Chinese authorities intend to exploit the “indexation effect” of Hong Kong’s stock through-train in the absence of China from mainstream global indices, a fund manager claims.

Speculative pressure in Shanghai stocks is being contained by mainland measures that are also pulling benchmarked investors towards China via Stock Connect.

It follows the freeing up of mainland mutual funds by Chinese authorities, allowing them to invest in Hong Kong equities via the cross-border trading scheme, sparking a huge surge of buying and a narrowing of the A/H share trading discount.

Mark Tinker, head of Axa Framlington Asia, has corroborated comments made by Peter Alexander of Shanghai-based Z-Ben Advisors, that recent dramatic moves in Hong Kong are all part of a bigger picture, which is the ongoing restructuring in Chinese financial services.

“The Rubik’s Cube of Chinese reform continues to click into place,” said Tinker.

“The biggest story in equity markets over the last two weeks has been Hong Kong, where a wave of mainland Chinese retail money has come down on the southbound through-train, pushing up prices sharply.”

Over the last six months, the Shanghai Composite Index has risen by more than 70% in dollar terms, fuelled by a wave of retail buying. By contrast, at the end of the first quarter, the Hong Kong market was up only around a tenth of that.  As a result the discount between A and H shares has widened to a new 5-year high.

Historically there has been no shorting allowed in A shares, so the main mechanism for correcting the A-share premium has been simply that A shares sell off or H shares rally.

Tinker reckons the latest moves in the Hong Kong market are part of a deliberate policy by the authorities to simultaneously calm down the Shanghai market while boosting their longer-term ambitions for international capital.

At the end of March Chinese authorities announced that mainland fund management companies would be able to invest in Hong Kong equities via Stock Connect, but without needing to have a licence under qualified domestic institutional investor, the quota system governing outward investment.

Southbound volumes immediately jumped from 12% of quota to more than the available daily quota and H share prices followed accordingly. The A-share premium dropped from 135 to 123. “Still a long way from the discount of last October,” (when the A/H premium index calculated by HSI stood at 102) “but certainly normalising,” said Tinker.

He claims “the clever bit” is how the Chinese authorities plan to exploit the indexation effect.

“After its recent run, the market cap of the Shanghai market would place it second only to the US. But crucially, it is not in the major benchmark global indices, on account of the RMB still not being a fully convertible currency. As such it can be ‘ignored’ to a large extent.

“However, the Hong Kong dollar is fully convertible and while Hong Kong is equally small in the global benchmarks, due to the exclusion of A share weightings, international investors can now access China via Hong Kong.

“Fully weighted, Hong Kong’s market capitalisation is now around $4 trillion, larger than Japan and second only to the US.  As such it will almost inevitably start to drag in index money, simply as a way of reducing risk and when the RMB becomes fully convertible, the rush to benchmark will be huge.”

Tinker added: "The likelihood is that because of the indexation effect, the jump in Hong Kong will not be ignored by asset allocators and the desired international capital will start to flow towards Hong Kong and by extension China. This will present an ideal opportunity for the banks and others to recapitalise via equity (a key part of their longer term plan)."

Meanwhile, Z-Ben’s Alexander believes China’s credit markets could explode into life, fuelled by massive latent demand.

He told AsianInvestor: “Over the last two years, when the QFII programme picked up momentum, we have had a lot more interest from sovereign wealth funds, corporates, pension funds and endowments.

“From these conversations, the number one consideration was they wanted to get their RMB exposure in the credit markets, not the equity market.”

He used the example of the Hong Kong Monetary Authority, which has $2.5bn of qualified foreign institutional investor quota, of which $1.5bn is in the interbank bond market.

These institutions want to be in China and it’s hard to believe they don’t have any international exposure to China, Alexander said. The entire focus for investors continues to be on Chinese equities, but the demand for bond exposure is massive.

The problem is that no one asset manager has forged a track record in this sector. Alexander said: “Who can you point to and say ‘that’s who I’d go to for my local RMB piece’?”

Chinese fund managers would be best placed to serve this demand, he says. “They have access to the interbank bond market, which foreigners do not,” though he adds that that too “will change in short order.”

“Chinese asset managers need to go after it though, to establish themselves. Otherwise, if there’s a sign of opportunity, it wouldn’t take more than a few months for the global players to get into position.”