The London-Shanghai Stock Connect: A Risky Proposition
With the uncertainty surrounding the upcoming Brexit — UK’s exit from the European Union — London is understandably keen to establish connectivity with China, the world’s second-largest economy, through the London-Shanghai Connect. It also seeks to retain its relevance and primacy as a financial hub. But forging stock market links with the bourses of Sydney, Hong Kong or Singapore would be more beneficial that pursuing a tie-up with Shanghai.
This is especially relevant if it seeks to tap the opportunities arising from a desire to join the TPP and access the economic opportunities arising from the RCEP — Hong Kong is keen to forge a trade agreement with its former colonial master.
This comes amid shifts in global trade brought about by the Brexit, the US withdrawal from the Trans-Pacific Partnership (TPP), and the renegotiation of the North American Free Trade Agreement (NAFTA).
Hong Kong, Singapore and Sydney offer a more natural fit, comparable regulatory regimes, a shared language and common history, with the possibility that they are likely to see more trading than the link with Shanghai.
But one commentator from Reuters highlights how while it enables foreign capital inflows, it retards the exit of that capital from within Chinese capital markets.
Pete Sweeney, the Asia Economics Editor of Reuters, observed: “The stock connect schemes, meanwhile, are designed to prevent capital outflows: Chinese investors can buy Hong Kong stocks, but the funds are converted back into yuan when they sell.”
“Besides, even the current quotas go largely unused; on Wednesday, for example, foreign investors used only 248 million yuan of the 13 billion yuan available to buy shares in Shanghai. China may be opening its financial market door wider than before, but it only opens inward.”
The impact of such a stock market link may also be overstated; Greater China investors tend to possess a significant domestic bias — much like the investor base of South Korea and Japan. Moreover, Singapore’s experiences with financial irregularities of Chinese firms termed S-Chips that were listed in the Singapore bourse, suggest caution and enhanced scrutiny will be required by European investors with an appetite for such stocks.
On a broader scale, despite the scale of its growth, China is argued to be an overstretched hegemon that is grappling with both external frictions and internal schisms. While it will unquestionably emerge and remain a Great Power, its ability to grow into and sustain itself as a superpower is questionable.
While undoubtedly an economic superpower, its declining and aging population are a risk to its international ambitions. Bloomberg notes: “When the U.S. was in a similar position, emerging to overtake Great Britain as the world’s dominant superpower, from 1880 to 1950, its population tripled.”
London-Shanghai Connect Problems
The London-Shanghai Stock Connect is not a trading link due to the time differences and technical challenges involved. Rather, it is a tie-up between the London Stock Exchange (LSE) and the Shanghai Stock Exchange (SSE) that will enable companies listed in either bourse to issue global depositary receipts (GDRs).
Chinese brokerage Huatai Securities Co. is planning to sell at least $500 million of GDRs in London, while HSBC is considering listing its shares on the equity link. Meanwhile, analysts from Goldman Sachs Group Inc. suggest that companies with long trading histories will explore options related to the link. It also opens up options to revive the Chinese depositary receipt (CDR) regime.
Companies seeking to issue securities on the London-Shanghai Connect will have to meet specific quantitative requirements, with investors able to swap London-listed depositary receipts for company stock 120 days after a new listing, according to the China Securities Regulatory Commission.
But the history of other trading links in the region are not so positive. In 2017, the bourses of Thailand, Malaysia and Singapore quietly discontinued their region-wide trading link, the ASEAN Trading Link, which started with Bursa Malaysia (BM), the Singapore Exchange (SGX), and The Stock Exchange of Thailand (SET).
When launched, it was heralded as a single gateway to the largest stock markets in the region, with the bourses of Vietnam, the Philippines and Indonesia eventually expected to take part.
However, stockbroking firms throughout ASEAN already maintained links to their own counterparties prior to the conceptualisation of the ASEAN Trading Link. And the same applies to the Chinese securities market; most international investors can access Chinese securities through broker-dealers and other parties in Hong Kong.
In a 2016 research report, “The Future of Chinese Capital Markets”, authored by Dr Flora Huang, a Senior Lecturer in Law, School of Law, University of Essex, she observed: “The Shanghai-Hong Kong Stock Connect creates the second biggest stock market in the world, with a combined market capitalisation of over US$7 trillion and annual turnover of more than US$9 trillion.”
“By adding the soon-launch of Shenzhen-Hong Kong Stock Connect and Shanghai’s International Board, China will further liberalise its capital account to international investors and build up a single Chinese market by consolidating the strengths of the three stock exchanges.”
“The stock exchanges also will likely derive greater economies-of- scale advantages from integration, both in their operations and in their trading of stock. On the operational side, integration can generate trading efficiencies by enhancing market liquidity and minimising market fragmentation,” Huang added.
But their investment publics (i.e. retail investors) and broader investment community (i.e. institutional investors) maintain a significant domestic bias, while a 2015 report by economic research firm Capital Economics suggested the stock connect was “more hype than substance”.
In an April 2018 op-ed for Bloomberg Opinion, Nisha Gopalan highlighted the problem of home bias by investors — though there are ways to ameliorate this bias via highlighting benefits of diversification — as well as the issue of investor awareness and appetite for stocks in different countries.
There is inadequate evidence to indicate an appetite in the British investment community for Chinese securities. According to Morgan Stanley, four Hong Kong-traded Chinese stocks with dual listings in London — Air China Ltd., Sunny Optical Technology Group Co., Datang International Power Generation Co. and Zhejiang Expressway Co. — have negligible trading volumes on the London bourse.
Moreover, Morgan Stanley indicates that Shanghai and Shenzhen’s stock connects with Hong Kong see less than 15% of the daily quota on both links being used up.
However the inclusion of mainland Chinese stocks in the MSCI Emerging Markets Index could drive passive to China, a development likely to take years to materialise. The London-Shanghai Connect could easily remain a moribund equities environment, even without factoring in regulatory and language frictions.
Beyond the challenges of building up investor literacy of investment opportunities and possibly growing the appetite for the different stocks, the problems facing the London-Shanghai Connect are compounded by technical challenges that include the time difference between London and Shanghai; the semi-fixed renminbi; continued capital controls; as well as friction caused by regulatory, cultural and language differences.
An information asymmetry will also exist between London and Shanghai due to geographic and regulatory distance, as compared to Shanghai with Hong Kong. London’s smaller renminbi supply also means that London will not be able to clear trades as easily as Hong Kong.
Chinese Capital Market Risks
The Shanghai and Shenzhen stock market links with Hong Kong have garnered substantial attention. Meanwhile,Chinese institutions have acquired stakes in Bangladeshi and Pakistani securities market operators, as well as formed a joint venture (JV) with Deutsche Boerse AG in Frankfurt that will enable Chinese firms to access European capital.
But China’s markets also pose a more near and medium-term risk in the form of high levels of corporate debt, a phenomenon that People’s Bank of China Governor Zhou Xiaochuan has highlighted. While this credit has underpinned substantial global growth in recent years, there is a credit crunch that has spread to overseas investors, with its private sector debt posing a risk to global economy that could see market turbulence within 3 years.
Beyond the potential hazards of Chinese equities and debt — one that could burst in the coming years — China is shifting towards a services-based economy more dependent on innovation and consumption for growth.
Distilled in the fundamentals of Made in China 2025, Beijing has reformed its capital markets and issuance system to facilitate this transformation. It has also moved away from investments in fixed assets and infrastructure into softer innovation assets (e.g. investments into artificial intelligence).
But the rout of Chinese equities also highlights the deep and underlying problems of the Chinese economy. In an exchange with Knowledge@Wharton, Marshall Meyer, Wharton emeritus professor of management, argues that more than its slowing economic growth or the trade war with the US is the discovery by rating agency Standard & Poor’s of “huge hidden debt” estimated between $5.5 trillion and $6 trillion.
This is coupled with collateralised debt that underwrites the purchase of shares by individuals in China’s stock market; this has quadrupled to more than 6 trillion yuan (US$898 billion) and is reportedly 10% of of the total value of China’s stock market. Meanwhile, since the start of 2018, the Shanghai Stock Exchange Composite Index has declined 25%.
There is also the affiliated problem of China’s growing household debt, which has seen indebtedness grow relative to disposable household income since 2007.
This draws comparisons with the debt booms seen in the US in the 1920s prior to the Great Depression and Japan in the 1980s, with indicators not being encouraging.
Matthew Klein, a columnist for FT Alphaville, traces the roots of China’s corporate debt boom to government-backed companies being financed by loans from government-controlled banks.
However, he argues that “losses from centralised credit allocation” can be distributed over a broad population over a long period of time”, while household debt sees borrowers being more disperses and lacking political power.
While corporate debt may financing additional infrastructure and economic capacity, household debt is unlikely to pay for productive investment. Notably, the growth of household debt has outstripped income in China since 2009.
Meyer explains: “The number and percentage of collateralised shares has gone up, but the value has plummeted as the Chinese stock market has gone down.
There will be a lot of margin calls this quarter (requiring investors to cough up more capital against borrowings), so we could expect all kinds of reverberations not necessarily due to the trade war.”
Currently, Beijing is pursing a policy of reducing debt and de-risking the economy, with the aim of lowering financial system risks and underwriting more sustainable economic growth. A senior adviser to Xi Jinping predicts that China will arrest its debt problem by 2020.
But it has also encountered resistance over debt associated with its investments in the Belt & Road Initiative (BRI), a geo-economic infrastructure initiative. While Beijing emphasis the lack of a political dimension, its financing model is unsustainable and involves Chinese loans to pay for Chinese contractors.
An analysis by the Center for Global Development, a nonprofit research organization, suggests that countries such as Djibouti, Kyrgyzstan and the Maldives, part of the BRI, that are part of the OBOR project will find themselves vulnerable to above-average debt from implementing these projects.
To date, Sri Lanka remains the most visible case, due to the inability of Colombo to repay the debt and its outcome — majority Chinese ownership of Hambantota. “You’re seeing in Sri Lanka a lot of pushback against this debt, which when defaulted on results in a Chinese takeover — a lot of resentment. In that respect the infrastructure investment has not worked quite as planned,” observes Meyer.
Nathan Hayes, an economist at Timetric’s Construction Intelligence Centre, observes: “As China has developed economically, its global political strength has also increased. The Chinese government has facilitated outbound investment in the form of equity stakes in projects and physical assets across the globe, particularly to secure access to resources.”
Sri Lanka is the exemplar of this debt trap, which has seen it lose ownership and control of the port at Hambantota and seen its currency suffer, though its prime minister has argued that the country is not as vulnerable as it seems.
Governance and regulatory risks
Growth of Chinese government debt to GDP. Credit: TradingEconomics.com
Arthur Kroeber, a non-resident senior fellow at the Brookings-Tsinghua Center and head of research at economic consultancy Gavekal Dragonomics, argued in 2015 that while China “…no longer enjoys the tailwinds of favorable demographics and booming global export markets”, its ability to guide markets such as agricultural commodities remained intact due to Beijing’s ability to manipulate supply and demand via control of physical inventories.
But the case of China’s stock market turbulence in 2015 and the subsequent intervention by Beijing, while arguably saving its stock market and ensuring stability, is likely to see more volatility in coming years. Beijing’s response unsettled investment professionals.
A Foreign Policy contributor observed: “China needs a functioning stock market that allocates investors’ capital to the most promising enterprises. This means prices that aren’t obedient to the whims of the state, or the party. China may have arrested the stock market’s fall by threatening to arrest sellers. But when it did that, it destroyed the town it was trying to save.”
The current situation, exacerbated by the Sino-US trade war, aligns with a prediction that the repercussions of the 2015 market intervention will resonate down the line. This would see fallout from the intervention focused on the Chinese state, it’s affiliated financial institutions, and the overall reform process.
In 2015, Junheng Li, the CEO of equity research firm JL Warren Capital, observed: “While the stock market was not a very important part of the financial transmission mechanism and the equity issuance accounted for a small part of external corporate funding, therefore, the boom and bust has contained damage to an already weakening economy. “
“The Chinese authorities did nothing to discourage the stock market bubble. Many welcomed it because they saw it as a painless way of deleveraging excessively indebted corporate (including SOEs) and banking sectors. Then, when the market crashed following a minor tightening of margin requirements, they intervened in the most heavy-handed way imaginable.”
She added: “Many Chinese and foreign investors will hesitate to go back into a market where you may not be able to get out when you want to (even when the daily 10% limit on individual stock price declines has not been reached), where you can be forced to buy more stock than you want to and where the authorities can compel private participants to put their money at risk by having to create a stabilization fund.”
Political risks & capital flight
President Xi Jinping’s consolidation of political power and increasing authoritarianism, as well as the removal of term limits, represents a transition to a new paradigm away from the doctrine of ‘Deng Xiaoping Thought’. While the effects may be positive, the performance of capital markets under autocratic control tends not to be positive, though in some cases international investors can enjoy affinity for autocracies and enjoy higher rates of return.
But the changes that have seen Xi consolidate power may signal that the current wave of reforms have come to an end, following the removal of the two-term limit that will enable Xi to remain in office beyond 2023.
This political development has apparently prompted a number of wealthy Chinese individuals to shift their assets overseas. A growing number of high net worth individuals (HNWIs) in China are relocating their wealth to Singapore rather than Hong Kong. This is due to the perception of distance from Chinese regulators and greater privacy in its banking sector.
The consolidation of power by Xi Jinping has also increased the possibility of a second wave of capital flight occurring, rooted in a meld of fundamental and psychological factors. A segment of Chinese investors perceive real or imagined risks that could motivate them to move capital outside China, in order to prevent their wealth being misappropriated or otherwise lost. Such capital movements can be compounded and amplified by investor herding, as well as panic.
Since 2009, China’s financial system and its large corporates have also become highly leveraged, though as of 2017 Beijing has pursued a deleveraging policy. But there is also a trend of the Chinese government acquiring stakes in companies unable to repay their debts and ties in with how the wave of Chinese acquisitions of overseas businesses ended badly.
In an op-ed, Christopher Balding, a former associate professor of business and economics at the HSBC Business School in Shenzhen and Bloomberg columnist, explains: “Productivity and profitability often matter less than politics. The government regularly publishes a list of industries it wants firms to invest in, and regulators must approve all aspects of a proposed deal, from the purchase price to whether firms can obtain foreign currency.”
“Reliably, companies planning to invest in preferred industries get the most approvals. And when state-owned banks determine which deals get financing, they tend to favour those that will advance government objectives. This process creates a range of problems. One is that the overseas targets often don’t make a lot of sense.”
These Chinese companies, which benefit from “preferential access to capital and near-impenetrable protectionism”, often encounter much tougher competition and a lack of tolerance for business practices that may be commonly accepted in China. Moreover, China’s state-owned enterprises (SOEs) who may possess higher financing capacity often see their stocks underperform their privately-owned peers.
Beijing also continues to be heavy-handed in its approach, with the recent arrest of the President of Interpol, Meng Hongwei, exemplifying this strong-handed behaviour. Additionally, his arrest highlights the opacity of China’s courts.
In an interaction with Bloomberg, Gu Su, a professor of philosophy and law at Nanjing University, explained: “The Interpol chief’s case exposed that China has for some time not followed judicial process in dealing with corrupt officials. The international backlash should serve as a wake-up call to the party, since there are obvious flaws in China’s approach of handling Meng’s case.”
This could just as easily be the case for senior executives of a London-listed firm travelling to Shanghai; travel to China by executives of UBS and Julius Baer has been restrictedfollowing the arrest of a wealth management executive in China, unsettling private bankers.
Meanwhile, earlier this month, Reuters reported that Beijing suspended approvals for a niche overseas investment scheme, urging license holders to tone down their marketing amid concerns over US-China trade war’s impact on the renminbi and concerns of capital outflows.
Conclusion
As China’s equities markets open up to international investors — the connections between mainland China and Hong Kong have benefited the investment community as they gained traction — with reforms to their issuance system for new shares coupled with reduced investment and listing regulations for overseas issuers, it is likely to evolve towards the patterns seen in the capital markets of South Korea and Japan.
The Korea Exchange (KRX) and Tokyo Stock Exchange (TSE) are very deep and liquid markets with signifiant turnover velocity; according to Stock Market Clock, as of March 2018, the KRX reports an aggregate market capitalisation of US$1.66 trillion while the TSE reports an aggregate market capitalisation of US$6.18 trillion.
However, both these markets are highly insular; their base of retail and institutional investors can be characterised as possessing a strong home bias. They are also constrained by differences in language, friction and regulations, which makes it challenging for international issuers to build and sustain investor interest, as well as access the associated liquidity in their securities markets.
The Shanghai-London Connect only goes halfway, with concerns over whether it represents symbolic rather than substantive market reform in China. The link increases the exposure of London’s investment community to the risks — as well as access to the opportunities — arising from China’s growing capital markets and its underestimated economic potential.
The Shanghai stock market peaked in 2015, in a manner not dissimilar from US market cycles over the last 20 years. But the Shanghai Stock Exchange has over 200 million retail — larger than the population of any European nation — and in 2017 emerged as the second largest IPO market globally, in terms of proceeds raised.
While the London bourse shouldn’t ignore the opportunity that a link to Shanghai represents, its investor community is also being exposed to significant risks across the socioeconomic and political dimensions through deepening its connection to the Chinese securities market.
This is not to say that China is the only country with a major corporate debt problem; the US has its own corporate debt problem to grapple with. Interest rates kept artificially low have led to risk being misplaced in the US, with bonds higher than they should be and yields lower. An example of this is a US$3.75 billion leveraged loan floated by technology insurer Asurion floated in the middle of the year that saw minimal covenants protecting creditors.
Fundamentally, with the UK’s desire to link with the CPTPP — through the benefits for the UK are unclear — it is probably better off forging connections to the Australian Securities Exchange (ASX), which is emerging as the ‘Nasdaq of Asia’. The UK and Australia share deep ties across both economic and cultural spheres, with a common heritage and multifaceted relationship.
Alternatively, the Singapore Exchange (SGX), which has forged co-listing agreements with the Tel Aviv Stock Exchange (TASE) and NASDAQ, creating an ‘East-West’ channel, is another candidate that could offer strong synergies. Both London and Singapore are major offshore RMB centres.
London emerged as the second largest RMB clearing centre in 2016 while Singapore is predicted to emerge as major RMB hub by 2020 and is a major FX and derivatives trading centre. This provides a strong foundation for synergies to develop between the two.
Both the ASX and SGX represent potential partners with more to offer for less risk to London. To all indications, the London-Shanghai Stock Connect is more symbolic than substantive in the benefits it represents for either London and Shanghai.
Looking at the broader picture, there are likely to be few material developments and benefits for either London or Shanghai arising from the link, particularly at a time when both the UK and China are set to undergo significant fluctuations in their economies in the medium-term.
This article was first published on LinkedIn.
