Shanghai-Hong Kong Stock Connect Doesn’t Quite Connect

October 29th, 2014

Zoe Sophos

The opening of China’s long-awaited Shanghai-Hong Kong Stock Connect, a trading link that would allow more foreign investment in China’s stock market, was delayed indefinitely on Monday. Bourse managers offered no explanation, but told the Wall Street Journal that Hong Kong’s democracy protests “might have played a role.” Also playing a role was a call last week from major banks and asset managers to delay the launch due to uncertainty over exchange rules.

Known as the “through train,” the exchange would—for the first time—allow foreign investors to directly trade Chinese A shares on the Shanghai Stock Exchange (SSE) and allow mainland residents to access Hong Kong’s stock exchange (HKEx). The linkage would add $2 trillion in stocks to the global equity market, according to UBS AG, and would create the world’s third largest equity market behind the New York Stock Exchange and the NASDAQ. Yet despite demonstrated interest from all parties—Goldman Sachs Group Inc. has labeled it “too big to ignore”—a lack of clear rules on taxation is causing some investor hesitation.

A slow start

The stock connect was originally announced by China’s State Administration of Foreign Exchange in August of 2007, and would have allowed qualified Chinese mainland residents to invest in the Hong Kong market. However, the scheme was abandoned on concerns that the new exchange would siphon funds away from mainland exchanges and expose Chinese investors to more risk. It wasn’t until April of this year that definitive plans for a stock connect between Hong Kong and Shanghai were revealed in a high-profile speech by Premier Li Keqiang and a joint announcement from the China Securities Regulatory Commission and the Securities and Futures Commission of Hong Kong. The announcement aimed to open the stock connect within six months, and HKEx indicated in September that the launch date would be October 27.

This launch date was postponed following a plea from the head of the Asian Securities Industry & Financial Markets Association to Hong Kong’s Securities and Futures Commission. In a letter dated October 17, the association said that it was “alarmed” that trading could begin as soon as the last week of October due to “uncertainty surrounding some technical issues and a lack of clarity over taxation,” according to Reuters. Confusion regarding capital gains taxes, dividends, and other issues surrounding corporate profits were cited as additional reasons for investor hesitation.

More investment opportunities

Importantly, the stock connect is part of a bigger plan to open more areas of China to foreign investment. Although investment has an annual quota of $48 billion, investment licenses  will no longer be needed for foreign investment in the SSE. Under the current system, only institutional investors in China’s Qualified Domestic Institutional Investor program (QDII) are permitted to invest in Chinese markets, and investment is capped at $105 billion. A full breakdown of the differences between the Shanghai-Hong Kong Stock Connect and the QDII programs is available here on the SSE website. Not only would the exchange make it easier to invest in China’s capital markets, but it is a potential harbinger for more plentiful investment opportunities in the future. The Shanghai-Hong Kong Stock Connect is technically a “pilot” program, which means it has the potential to be rolled out to other exchanges such as the Shenzhen Stock Exchange or London’s Metal Exchange, which was purchased by HKEx in 2012.

Yet, throughout the long launch of the stock connect, risk management has been a primary consideration for Chinese regulators. Foreign investors are not allowed to buy and sell shares on the same day, and new rules were added to avoid manipulation of daily trading limits. Further, the combined two-way trading volume of the exchange will be capped at about 20 percent of the trading value of both markets combined; investment into Shanghai has a daily limit of RMB 13 billion and an aggregate limit of RMB 300 billion, and investment into Hong Kong has a daily limit of RMB 10.5 billion and an aggregate limit od RMB 250 billion.

The exchange would provide more, simpler opportunities for investment in the Chinese equities market, and it is a good sign that China’s regulators are on a path towards letting market principles have freer reign. Stringent regulations and a lack of specificity on taxation rules, however, mean that the definitive impact of the exchange remains to be seen.