Shanghai-Hong Kong Stock Connect has just passed its two-month anniversary, and continues to grow steadily. The scheme is operating smoothly, with Southbound turnover gradually picking up towards the Northbound level. While we continue to tweak and improve the existing Stock Connect scheme, we are looking forward to where we will go next.
As we work towards a link with Shenzhen Stock Exchange, we are already thinking ahead about how Mainland capital markets will further open up in the Stock Connect era. Discussing the development of an Asian wealth management centre at the Asian Financial Forum yesterday, Chairman Xiao Gang of the CSRC stressed the long-term impact that the internationalisation of Chinese markets will have on the established global market order. In my blog today I would like to discuss the possible implications of the Connect programme and how that could impact the way we prepare ourselves for the accelerated pace of opening of China's capital markets. More specifically, I would like to raise a few questions:
1. What is the backdrop of China's capital market liberalisations against which the Stock Connect programme was conceptualised?
2. What is the essence of the Stock Connect model that makes it work – the emergence of a "Mutual Market"?
3. What are the key features of the "Mutual Market" embodied by Stock Connect that makes it unique and valuable?
4. How does Hong Kong move from Stock Connect to a more comprehensive "Mutual Market" encompassing other products and asset classes?
1. What is the backdrop of China’s capital market liberalisations for the Stock Connect programme?
China today is closely connected globally in terms of its economic fundamentals; its financial system and capital markets are, however, still largely closed. As the second largest economy in the world, its currency is still not freely convertible. There is wide consensus both inside and outside of China that this is unsustainable and that China will inevitably accelerate the pace of opening up its capital markets. As China treads the path of capital market liberalisation, it will naturally have a tremendous impact on its citizens' livelihoods and entail enormous risk and responsibility for the country's leaders.
On its surface, opening up is simple enough: either international investors are allowed in, Chinese investors are allowed out, or both. In reality, this is easier said than done. Given the gulf between China's legal and regulatory standards and those of the rest of the world, it will take years before international investors are able to arrive in large numbers. Setting Chinese capital completely free runs contrary to the instinct of control and raises concerns of capital flight. Besides, Chinese investors have never had any meaningful exposure to the outside world and are highly unlikely to venture out lightly in any event.
It is against this backdrop that the key conceptual framework of Stock Connect was designed, such that it could capture the consensus and support of policymakers and regulators, and which ultimately led to the historic breakthrough.
2. What is the essence of the Stock Connect model that makes it work – the workings of a "Mutual Market"?
The greatest significance of Shanghai-Hong Kong Stock Connect is that it provides China with an interim model for opening up before it is completely ready for the large-scale arrivals of international investors and departures of Chinese domestic investors. The interim model works like a "Mutual Market" whereby investors on each side of the boundary are able to trade products of the other market within their home time zone, relying on their home market infrastructures. With the joint oversight of the two regulators, capital flows from China and international markets are able to congregate and interact with each other in this "Mutual Market", facilitating the gradual convergence of the Mainland and international markets.
This model has the potential to be extended to other products, including equity derivatives, commodities, fixed income and currencies. Those Chinese capital markets products that are of interest to international investors can be placed in this "Mutual Market", while those international products that are needed by Chinese investors can be added, thereby enabling Chinese investors to diversify their investments and hedge against international price risks. In this way, a swift and large-scale opening up of China’s markets can be achieved, giving China greater international market and pricing influence without waiting for lengthy and extensive legal and regulatory reforms to be carried out first. And with the currency of transaction being the RMB, this "Mutual Market" would further accelerate the internationalisation of China’s currency, helping to realise yet another goal.
3. What are the key features of this "Mutual Market"?
i. Close regulatory cooperation between the two markets. Building on the Stock Connect model, the joint regulatory model would import the best features of both markets. The trust and confidence developed and the model of regulatory collaboration and enforcement assistance will be the foundation for the expansion of the "Mutual Market".
ii. Gross order routing ensure maximum price discovery and revenue sharing ensures alignment of interests. Orders from each market are electronically routed in gross into one matching engine in the target market, ensuring one price discovery point. Shared economic interests allow the two exchanges to aggressively strive for success in both markets.
iii. Clearing and settlement in home market first before net settling between the two CCPs. Such a clearing model minimises cross-border fund flows and helps preserve the integrity and independence of the clearing houses in each market.
iv. Home market norms and practices for investors. Investors in each market can continue to rely on existing infrastructure, including brokers, trading platforms and clearing systems, while continuing to benefit from protection from their domestic regulator.
v. Expanded fundraising market for issuers. Companies seeking capital would benefit from a larger pool of investors and enhanced liquidity.
vi. Enhanced risk management tools for capital markets users. For companies and investors, they would be able to access a wider number of derivatives to help manage market and economic risks.
vii. Greater incentives for intermediaries. Expands the pool of international products that Chinese intermediaries are able to offer their clients, fostering a natural process of international integration of the Mainland brokerage market.
The Stock Connect model has in essence created a new "Mutual Market" between the Mainland, Hong Kong and international capital markets. Through this two-way, scalable, closed-loop structure, international capital and products have been brought to China's doorstep for Chinese investors and vice versa, all taking place in an environment where risks are transparent and easily controlled.
4. How does Hong Kong move from Stock Connect to a more comprehensive "Mutual Market" encompassing other products and asset classes?
Shanghai-Hong Kong Stock Connect is really just the opening act for the "Mutual Market", with its potential far from fully exploited. In addition to the cash equities that are available now, there are many more products that could be included in this model. However, in order to move forward, we need to have some sort of common ground with policymakers and regulators about what we do and how. Perhaps I can offer a few initial thoughts on this below.
Building on the equities link
With Shanghai-Hong Kong Stock Connect already established, there is a clear template for a Shenzhen-Hong Kong link in cash equities. The only things we need to consider are when to roll it out and whether we make some incremental improvements to the rules and trading mechanisms, and add a few more products.
However, if cash equities are the trunk roads supporting capital flows between the Mainland and international markets, equity derivatives are the junctions and slip roads that help regulate the traffic. Equity index futures help investors in both markets hedge their risks, and would be a helpful tool to smooth the transition to greater A-share inclusion within global market indices, such as the MSCI Emerging Market index.
In simple terms, there are two ways in which equity index futures could be incorporated into the "Mutual Market": via cross-border licensing of index benchmarks or through the more comprehensive method of allowing cross-border trading. We are in close discussion with our partners and regulators to explore the best way forward.
Addressing urgent needs in the Mainland commodities markets
From an objective standpoint, if you ignore all the structural impediments, all China would need to do to internationalise its commodities markets would be to invite foreign investors in. However, given the realities of a closed capital account and wide differences in the legal and regulatory framework between China and the outside world, it will still take some considerable time before the Mainland commodities markets can be fully internationalised on its home soil.
Notwithstanding the fact that China is today the largest consumer and producer across a number of commodity classes, it is frustrated that it still feels like a "price taker" rather than a "price setter". If China truly intends to secure its rightful place in influencing international commodity prices, it will need to take bold action and allow its capital and/or products to go international and exercise its influence in the international markets.
The crux of the issue is how to do all this? And should it be done alone or in partnership? In partnership with whom? And can partnership in the commodities area be a lasting win-win? Commodities derivatives are very different from equities and we need to carefully consider with the Mainland commodities exchanges how we can achieve an opening up of the market in a mutually beneficial way. I hope that we will be able to reach a suitable solution soon, and am convinced that the "Mutual Market" model will be the key to resolving this.
Liberalisation in fixed income and currencies is already steaming ahead
Reforms have been accelerating in China's interest rate and foreign exchange markets. However, as fundamental pillars within the capital markets, any shifts in policy in these areas are likely to have significant reverberations around the entire market. Given the complexities, the pace of reform needs to be measured in order to properly control the risks.
Against this backdrop, Hong Kong's role as a testing ground for the offshore RMB market is all the more important. To fully leverage Hong Kong's function in this regard, we need to broaden and deepen the offering of RMB interest rate and currency derivatives here. Initially, this can be through the licensing of Mainland benchmarks, gradually adding Mainland liquidity to the mix.
Rapid developments in the primary market present new opportunities and challenges
Primary capital raising is one of the most basic services provided by the capital markets to the real economy. Does the "Mutual Market" have a role in this? Hong Kong has long served as the primary offshore capital formation centre for China; with the accelerating reforms in the Mainland (particularly around registration-based IPO reform) coupled with the massive pools of domestic capital chasing primary issues of equity, there could be profound implications for the Hong Kong stock market going forward.
We need to carefully analyse the changes and the options available to corporate issuers, and consider how best to maintain our competitive advantages in this new environment:
- Mainland issuers often choose to list domestically because investors are familiar with their company and are willing to grant them a premium valuation due to substantial demand for new issues. However, this market has historically been constrained by uncertainties created by regulatory interference in the market, preventing issuers from having certainty about the timing or size of capital raising;
- The main driver for Mainland issuers selecting Hong Kong is that we have an open and market-oriented capital raising regime, with access to international institutional investors. The downsides have traditionally been lower valuations compared with the Mainland, as Hong Kong IPOs are not available to be subscribed by domestic investors, and there are limitations on full fungibility with the Mainland;
- International issuers considering Hong Kong and the Mainland for listings primarily wish to attract Mainland investors, but often find themselves unable to cope with the legal and market structures in the PRC.
The factors most likely to affect the Hong Kong IPO markets are the Mainland's enormous liquidity and the accelerating reforms in the domestic capital markets. Correctly understanding and anticipating these changes are crucial to developing mutually beneficial win-win market solutions for the future.
In summary, I believe that the "Mutual Market" model can become a new template for China’s capital markets internationalisation, at least in the short to medium term. I've only raised many questions here and it will take our collective wisdom and efforts to find the right way forward. Without doubt, however, Hong Kong’s "one country, two systems" model provides strong underpinnings for us as the best "Mutual Market" partner for the Mainland.
So is the "Mutual Market" model the best option for Hong Kong? Can we be a part of this common marketplace without sacrificing or compromising our core values and standards? I believe so, but this is something that Hong Kong people need to debate carefully and decide.