Stock Connect: the inside view from China's equity markets

Stock Connect: the inside view from China's equity markets (in 60 seconds)

Stock Connect has been a breakthrough and is a much more efficient way for overseas investors to access China compared to QFII and RQFII programs;
Stock Connect has opened up China's A-share markets, boosted equity investment flows both into and out of China, and expanded its coverage to include 83% of the combined market cap of Hong Kong, Shanghai, and Shenzhen Stock Exchanges;
The introduction of Stock Connect is the primary reason why A-shares have been included in global index benchmarks and why global investor inflows into mainland China equities have accelerated;

But Stock Connect remains a work-in-progress. We'd like to see further changes to Stock Connect in terms of trade pre-checking, trading day alignment, and the scope for overseas investors to participate in A-share IPOs and the newly-formed STAR market;
For investors, Stock Connect offers a bigger set of investible opportunities and means greater scope to combine the best opportunities in China's equity markets in one optimal portfolio;
Because of Stock Connect and MSCI inclusion, we feel investors are changing the way they invest in China. That means considering allocating to China stocks on an All China basis, and also investing in China equities as a standalone investment class of its own, and not just as a subset of a generic emerging markets allocation.

Stock Connect: why did it start and how has it performed?

Stock Connect was introduced to improve investor access, speed up trading processes, increase the role of overseas capital in China's equity markets, and provide an outlet to Hong Kong markets for investors in China. Against all these criteria, Stock Connect has been very successful indeed.

Let's first consider the flow of overseas investors' capital into China A-shares. Northbound Stock Connect trading, meaning trading activity by Hong Kong-based investors in both the Shanghai and Shenzhen Stock Exchanges, has increased steadily since Stock Connect first launched on November 17^th 2014 and total turnover reached RMB 16.5trn by end of August 2019¹ .

Exhibit 1: Average Daily Turnover on Stock Connect Northbound - 60 day moving average (RMB billions), Feb 16, 2015 - Sep 16, 2019

Northbound Average Daily Turnover — Source: Bloomberg, September 23, 2019

Note: Turnover in this case is defined as total buy and sell trading volume. Northbound trading volume is denominated in RMB.

There's a similar picture with the flow of mainland China capital into Hong Kong. Southbound Stock Connect trading, meaning trading by mainland China-based investors on the Hong Kong Stock Exchange via Stock Connect, has also grown and total turnover came to HKD 8.5²trn by the end of August 2019.

Exhibit 2: Average Daily Turnover on Stock Connect Southbound - 60 day moving average (HKD billions), Feb 16, 2015 - Sep 16, 2019

Southbound Average Daily Turnover — Source: Bloomberg, September 23, 2019

Note: Turnover in this case is defined as total buy and sell trading volume. Southbound trading volume is denominated in HKD.

As flows have grown, foreign investors' share of China's A-share markets has increased. As of June 2019, foreign investors owned RMB 1.65trn (USD 230bn)³ worth of China A-shares, amounting to an estimated 7.3% of the total free-float A-share market capitalization, compared with approximately 3.2% in June 2016⁴.

All these trends have played out because of Stock Connect, and also because it has been improved and expanded during the past five years.

Stock Connect:

Covers 83% of the combined market cap of the Shanghai, Shenzhen and Hong Kong Stock Exchanges;
Includes 1,800 companies listed on the Hong Kong, Shenzhen and Shanghai Stock Exchanges;
Handles average daily trading volume of HKD 64.6bn in Q2 2019, compared with HKD 7.8bn in Q1 2015⁵

Exhibit 3: Stock Connect Average Daily Turnover (HKD Billions) Q2 2015-Q2 2019

Note: Data covers Shenzhen-Hong Kong Southbound and Northbound trading routes and Shanghai-Hong Kong Southbound and Northbound trading routes.
Northbound trading is conducted in RMB; Hong Kong Exchanges and Clearing convert the northbound figures in the chart into HKD based on the month-end exchange rate.

How has Stock Connect changed China equity investing for overseas investors?

Before Stock Connect, investing in China A-shares from overseas was possible but challenging.

Programs like QFII and RQFII gave access to A-share markets but approval periods were lengthy, trading processes were time consuming, and execution could be restrictive, all of which were challenging for active investors like ourselves.

For example, it could take weeks to apply for all the necessary licenses and quotas stipulated by the QFII and RQFII schemes in the past.

QFII trading also came with strict controls on buying and selling, and trading was done on a 'no fail' basis, and all these aspects made QFII investing cumbersome, but capital control restrictions also applied lock-up periods and repatriation limits, which meant we would go through periods where we were out of the market, which obviously wasn't ideal for us.

Stock Connect was introduced to remove the lengthy approval processes for trading, make investing more efficient, and open up China's onshore equity markets to global investors, but it wasn't an overnight success.

In the initial period after Stock Connect launched, trading volumes were lower than we expected and much lower than the initial quotas set for the program.

It took time for investors to adjust to the new system and build confidence in it, partly because the initial trading models were not as efficient as it is now.

One big change was the introduction of special segregated accounts (SPSA) in 2015. Through that, investors got individual accounts in the Central Clearing and Settlement System and could link to multiple brokers. This marked a big step forward for investors and brought Stock Connect closer into line with other trading systems used both in Asia and globally.

As trading volumes have grown, regulators have expanded trading quotas too to boost trading and inflows. In 2018, the China Securities Regulatory Commission (CSRC) quadrupled daily quotas, boosting daily northbound quotas on the Shanghai and Shenzhen to RMB 52bn yuan (USD8.27 billion) from RMB 13bn before.

Put together, Stock Connect has created an additional route for China equity investing. While it remains a work in progress, the attitude we are seeing from regulators tells us that it will likely be expanded and improved in the future.

China A-share trading With Stock Connect is simpler and quicker than using QFII and RQFII and regulators have moved quickly to improve it over the years.

What is QFII? What is RQFII? Find out in China Equities 101 here

Find out here

Why does Stock Connect matter for investors?

Stock Connect provides direct access to China's onshore markets, gives investors more choice of equity investment opportunities, allows investors to participate more fully in China's growth story, and opens up many opportunities for active strategies.

Exhibit4: Onshore/Offshore Markets Compared (No. of Stocks)

Average Daily Northbound Trading Volume on Hong Kong-Shanghai/Shenzhen Stock Connect (HKDbn), Q1 2017-Q2 2019

Source: Hong Kong Exchanges and Clearing Market, September 2019

Note: Northbound trading is conducted in RMB; Hong Kong Exchanges and Clearing convert the northbound figures in the chart into HKD based on the month-end exchange rate.

Investors get more choice of investible equities via Stock Connect.

If you only invest in China equity markets via H-shares or ADRs you have a relatively limited range of choices.

But Stock Connect gives investors access to a much wider range of stocks. That means a wider range of ways to participate in China's growth story and greater exposure to fast-growing, high-potential sectors like consumer and healthcare.

As important as quantity of opportunities, it's also about quality. Not every onshore company is included in Stock Connect but the ones that are included are, generally speaking, the best quality companies on the markets.

Finally, Stock Connect gives investors easier access to the onshore market that is still comparatively immature and inefficient, and that means a happy hunting ground for active investors like ourselves.

Though China's A-share markets have developed a great deal, they remain driven by retail investors, and that means they can be volatile and prone to mispricing.

That's a challenge for passive investors but an opportunity for active, fundamentally-driven investors because we can take advantage of mispricing, deviate from benchmarks, and allocate to the best opportunities wherever we see them, regardless of prevailing market sentiment.

How has Stock Connect changed China's onshore equity markets?

Stock Connect has indirectly improved corporate governance, driven the adoption of ESG standards/reporting, shifted investor behaviors, and brought about the inclusion of China A-shares in global stock indexes, like MSCI and FTSE Russell.

Looking at corporate governance, international investors expect A-share companies to adhere to international standards. Since the launch of the program, we have seen notable progress in terms of corporate reporting and disclosure.

On a related note, we are seeing more companies issue ESG reports, and this is an increasing trend. In fact, this is going to become a mandatory, not an optional, practice because China has introduced legislation to enforce compulsory ESG disclosure for listed companies from 2020⁶.

Additionally, China A share market becomes more fundamental driven, which we believe is down to more international money. Recent research by MSCI7 shows that fundamental factors like price-to-book and earnings quality have become much more influential in China's markets and we see that as a very welcome development.

Finally, without the changes introduced by Stock Connect, China A-shares would have a slim chance of going into global index benchmarks, like those operated by MSCI and FTSE Russell. Put simply, this index inclusion process is increasing the weight of China A-shares in global indexes and is a major driving force behind the trends of increasing foreign investor participation, improving standards, and growing flows both into and out of China's equity markets.

How is Stock Connect evolving?

Given the success of the initial Stock Connect, and the growing investor appetite for China stocks, we wouldn't be surprised to see further growth in the scheme.

Big picture issues aside, operational improvements to Stock Connect can still be made.

SPSA, though a huge improvement, still requires pre-checking. Removing that would simplify trading processes further.

Also, closer alignment of trading days would be better because Shanghai, Shenzhen and Hong Kong exchanges don't always trade at the same time.

Finally, Stock Connect doesn't cover IPOs and, at time of writing, it also doesn't cover the newly launched STAR market. There are moves to include these, but as of yet we are not clear on the timeline.

Stock Connect remains a work in progress and further improvements will likely be made to improve operations and also to further expand the scope of the program.

How can investors take advantage of Stock Connect?

We feel that Stock Connect means the old way of China equity investing no longer applies and that investors should consider an All China approach.

In the past, China equity investors used to allocate either to onshore or offshore markets. Now, these distinctions don't really apply anymore. Stock Connect means investors can now freely combine the best China equity opportunities wherever they are listed into one optimal portfolio.

This approach, which we call All China equity investing, is one which we think investors should be following now because, in time, it will be the way of the future.

We also feel that investors need to adapt their views of China in both global equity markets and the global economy.

After Stock Connect reduced barriers to onshore China equities, global index providers like MSCI and FTSE Russell realised that a major part of the global economy remained under-represented in their benchmarks.

As a result, these index providers have started the process of including China equities into their benchmarks to redress the balance.

As time goes on and index inclusion plays out, China's role in global benchmarks will evolve from being merely part of emerging markets to being a distinct, standalone category of its own.

This (overdue) evolution means investors must now consider China as a standalone allocation of its own, in much the same way that consider the US, UK, and Japan.

Stock Connect is changing China's equity markets and we feel the best way investors can adapt and take advantage is by considering China stocks from an All China perspective, and also allocating to China on a standalone basis.

Stock Connect: the inside view from China's equity markets