Shenzhen-Hong Kong Stock Connect a welcome reform

It'll allow greater foreign access.

It has been noted that the August 16 confirmation of the expected launch of the Shenzhen-Hong Kong Stock Connect in four months time (possibly before December 25) is a sign that Chinese authorities will continue to pursue equity market reforms in a bid to allow greater foreign access.

According to a research note from BMI Research, further liberalisation of the stock markets will allow international investors to diversify their portfolios, and should close the valuation gap between the same companies listed on Hong Kong and the mainland over the long-term.

Further, the China State Council's approval of the launch of the Shenzhen-Hong Kong (SZ-HK) Stock Connect on August 16 is in line with BMI Research's view that China will continue with its equity market reforms by opening up its financial markets to foreign investors.

The approval for the connect reflects the authorities intent in getting Chinese A-shares into the MSCI indices, following MSCI's decision to delay the inclusion of China's A-shares in its EM index for the third straight time on June 14. We also note that this liberalisation has come at a time when the Chinese yuan is still under downside pressure.

Here's more from BMI Research:

Following Premier Li Keqiang's endorsement, the various authorities, including the China Securities Regulatory Commission (CSRC), Hong Kong's Securities and Futures Commission (SFC), and the Hong Kong Exchanges and Clearing Limited (HKEX), also announced on August 16 that they will work together to launch the connect over the coming months. The final testing and preparatory work for the SZ-HK connect is expected take up to four months, with the Chief Executive of the Hong Kong Exchange stating that the link can hopefully be up before December 25.

The move to link up the Hong Kong and Shenzhen Stock Exchanges comes roughly two years after the launch of a tie-up between the Special Administration Region with Shanghai in 2014, and we believe that this is a positive step towards improving the efficiency of China's capital markets over the coming years.

We note that stocks of mainland listed companies are approximately 25% more expensive than the equivalent equities listed on the Hong Kong stock exchange, according to the AH Premium Index, but this valuation gap should close gradually as it becomes easier to arbitrage between the two markets.

We highlight that although the respective Northbound and Southbound aggregate quota of CNY300bn and CNY250bn has not been used up, there has been an increase in the usage of the Southbound quota since May 2016, and this has allowed the AH Premium Index to narrow.

The launch of the SZ-HK connect will add around 880 equities listed in Shenzhen to the 567 stocks already available to international investors through the Shanghai link, with ChiNext participation limited to institutional investors initially. We highlight that the launch of the SZ-HK link will allow foreign investors to diversify their portfolios into private and technology-related corporates, and avoid state-owned entreprises in overcapacity sectors that are often loss making.

Indeed, data from Bloomberg shows that information technology companies account for approximately 20% of the market capitalisation of the Shenzhen Composite Index [SZCOMP] (versus 4.4% for the Shanghai Composite Index [SHCOMP]). Meanwhile, financials (mainly banks) dominate the SHCOMP at 34.0%, compared with SZCOMP's 10.7%.

hinese onshore and offshore equities are breaking to the upside, and we believe that positive momentum is likely to continue in the near-term given the catalyst from the expected launch of the SZ-HK connect. However, given that the Chinese economy is still slowing, coupled with still elevated valuations on the SZCOMP, foreign investors are likely to adopt a cautious approach. Therefore, we do not expect them to rush into the mainland markets upon the launch. Instead, it is likely that mainland investors will take the chance to invest in the relatively cheaper Hong Kong market.