Landmark Shenzhen Connect heralds end of aggregate trading quotas

Almost two years after trading started on the landmark Shanghai-Hong Kong Stock Connect, a statement released on late Tuesday afternoon said all relevant preparation work for the Shenzhen Connect scheme had been completed and that the State Council had given the plan the green light.

The SFC revealed in a separate statement that the Shenzhen Connect will have no aggregate net trading quota. It also said the existing aggregate quotas under the Shanghai Connect will be abolished with immediate effect.

The SFC statement was followed in the evening by a media briefing held by the Hong Kong Stock Exchange (HKEX), where Charles Li, its CEO, explained that while aggregate quotas would be abolished, the existing daily net trading quotas would remain in place for both the Shenzhen and Shanghai links, at Rmb13bn ($2bn) each.

“The daily quotas are important given that it helps to prevent unforeseen large scale movements of capital,” said Li. “It helps keep the volatility in check.”

As for the launch timetable, Li said recent market tests had helped shorten preparation time and that a launch by year end was certain.

Another significant addition to the Shanghai Connect set-up would be the inclusion of ETFs to the universe of eligible products in 2017. However, Li said regulations would need to be adjusted first.

“The clearing rules [for ETFs] are not compatible between Hong Kong, Shanghai, Shenzhen, so further fine-tuning is needed between exchanges and regulators.”

Shares eligible under the northbound link for Shenzhen Connect will cover all constituent stocks of the Shenzhen Component Index and Small/Mid-cap Innovation Index, which has a market cap of no less than Rmb6bn. Stocks on the Shenzhen Exchange issued by companies that have issued H-shares are also eligible for trading.

For the southbound link, all stocks of the Hang Seng Composite Large Cap Index, Mid-Cap Index and Small Cap Index with a market cap of no less than HK$5bn ($645m) will be eligible.

In addition, Hong Kong-listed companies with corresponding A-share listings will also be eligible for trading under the scheme.

As for eligible investors, the only novelty is the decision to limit access to ChiNext stocks on the Shenzhen exchange to institutional investors. Li told GlobalRMB, a sister publication of GlobalCapital Asia, that further regulatory considerations were needed on that front. ChiNext is the exchange for smaller companies, predominantly those in the technology sector.

Hong Kong investors that are able to access ChiNext stocks will be limited institutional professional investors, meaning institutions only instead of high net worth individuals or other retail investors.

Li added that such investors would need to go through a yet-to-be defined certification process with the SFC. China, for example, also restricts retail participation in ChiNext by having investors sign a series of agreements to make sure they understand the risks involved in their investments.

“SFC needs to introduce or come up with similar criteria so that our investors can go through a similar process since ChiNext is made up of much smaller cap stocks, with more volatility and potentially more risk,” he said.

Li added that commodities and fixed income, as well as the remaining stocks not yet eligible for the scheme, are being targeted for future expansion.

“[Currency] Futures Connect is in the future,” Li said. “But we are in active discussions for derivatives based on A-share underlyings so that in the not too distant future we can offer hedging tools to investors that are accessing China's cash market. Many have communicated to regulators and exchanges, and we have so many of these international investors involved in the northbound market that they have significant genuine demand for hedging.”

Even before Tuesday’s announcement, many participants had said they did not expect the market impact of the Shenzhen Connect to be huge given the usage of the Shanghai Connect over the past 21 months.

The outstanding southbound aggregate quota is Rmb45.2bn or 18.08% of the total. Meanwhile, the northbound still has Rmb144.9bn remaining, which translates to 48.32% of the channel not being used, according to CEIC data as of August 16.

While Douglas Morton, head of research, Asia, at Northern Trust Capital Markets, agreed that Stock Connect flows have been disappointing, the Shanghai link did, however, initiate the largest Chinese rally since 2006/07.

A-shares experienced a more than 150% jump in the 12 months from May 2014, while Hong Kong market turnover rallied initially by 60% before peaking 215% higher in April 2015, putting it on par with the Tokyo Stock Exchange Price Index and the S&P 500 – the two most liquid indices in the world.

“Irrespective of expectations of its success, it was the Shanghai Connect announcements that catalysed all major market rallies over 2014/15, despite other profound reforms being announced over the 12 months,” Morton said.

A trading link between the Hong Kong and Shenzhen equity markets has been a long time coming. The China Securities Regulatory Commission first said it was considering the Shenzhen link in October 2014, even prior to the launch of the Shanghai leg. Then in March 2016, Chinese premier Li Keqiang pledged to launch the scheme by year end. 

The two exchanges had market caps of HK$24.6tn and Rmb21.8tr, respectively, as of Monday, according to CEIC data.

The March announcement was followed by many speeches from both Chinese and Hong Kong officials reaffirming plans to launch before the end of 2016 and momentum went up a notch when the HKEX released a testing pack for brokers on June 27.

Now that the scheme has been approved, the next question is when the authorities will start market-wide tests. Based on the experience of Shanghai Connect, it takes about two to three months of testing before the scheme is ready to go live, bringing the likely launch date to around the time of the second anniversary of the Shanghai link on November 17. In its presentation, HKEX said the scheme is expected to launch in about four months.

“[We] suspected that an announcement before the upcoming G20 meeting was most likely, which not only allows the government to demonstrate a continuous commitment to financial reforms, but also leaves enough time for the launch before seasonally-quiet December,” wrote Aidan Yao, senior emerging Asia economist at AXA Investment Managers.

The G20 meeting will take place in China on September 4 and 5.

Yao expects the State Council to specify the exact launch date soon and said he sees the scheme’s imminent launch as part of China’s continued efforts towards capital account liberalisation.

The decision to scrap trading quotas is a particularly notable reversal following Beijing’s decision to introduce capital control measures to stem capital outflows at the end of 2015.

The announcement also addresses index provider MSCI’s concerns about the accessibility of Chinese stocks. MSCI decided not to include A-shares in its emerging market index in June, and cited market access restrictions as one of the key outstanding concerns.

Macquarie’s research team agreed that Shenzhen Connect signifies an easing of capital outflow concerns and said the scheme will provide international investors access to China’s most dynamic equity market.

The bank said it expects the new scheme to offer better exposure to the high growth sectors of China’s economy.

As for the eligible list of stocks, the Shenzhen channel will offer the Shenzhen Component and the Small/Mid Cap Innovation indices. The two indices are made up 74% by private enterprises and new economy stocks, nearly twice the ratio for this type of company within the Shanghai Connect eligible universe. 

In total, some 800 Shenzhen stocks will become available to foreign investors under the new scheme, with more than 400 stocks from Hong Kong available to Shenzhen Connect investors and more than 300 available to Shanghai buyers.