Across The Border
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Stock Connects can act as perfect hedge against yuan’s fall

As closed-loops, the yuan-in, yuan-out system avoids capital flight, but helps hedge the depreciation risk of the currency

PUBLISHED : Wednesday, 02 November, 2016, 1:09pm
UPDATED : Wednesday, 02 November, 2016, 9:57pm

Mainland investors can hedge against the yuan’s depreciation through the Shanghai or Shenzhen Hong Kong Stock Connect scheme, which is one of very few channels still available to avoid asset shrinkage due to the weakening currency.

However, not all stocks can play the role, because China-asset backed stocks are still exposed to depreciation.

“If Chinese investors purely want to hedge against the yuan’s depreciation, they should consider real Hong Kong firms which do not have much onshore business,” said Aidan Yao, senior emerging Asia economist at AXA Investment Managers Asia.

China asset-backed stocks in Hong Kong, such as China Mobile or PetroChina Company, record earnings in yuan while their shares prices are denominated in the Hong Kong dollars, which are pegged to the US dollar at a narrow range of between 7.75 and 7.85 per US dollar.

If the yuan continues to fall against the greenback, the price-to-earnings (P/E) ratio of such stocks will become expensive and shares price may face a downside risk.

“Many mainland investors have home bias and prefer companies they are familiar with, but holding those stocks can’t help prevent them from the yuan’s depreciation,” Yao said.

Among the 314 tradable Hong Kong stocks under the Shanghai-Hong Kong Stock Connect, several Hong Kong property and utility stocks are suitable for mainland investors who see currency hedging as a priority, said Ivan Li Sing-yeung, head of research at Sinopac Securities.

They include Cheung Kong Infrastructure Holdings, Swire Properties which mainly collects rents from office buildings of the city, and local restaurant chain Café de Coral Holdings.

Some simple arithmetic explains the hedging process.

Imagine a mainland investor paying 87 yuan for a share in a Hong Kong firm priced at HK$100 when the exchange rate for offshore yuan is 6.7860 per US dollar.

Assuming the yuan continues to weaken to 7 per US dollar by 2018, investors will see their account appreciate to 90 yuan when selling the stock with the price unchanged at HK$100, therefore the value of their yuan asset is protected.

The mainland market currently lacks investable assets, and the Stock Connect solves the problem. It improves mainlanders’ asset diversification without leading to capital outflow
Aidan Yao, senior emerging Asia economist, AXA Investment Managers Asia

One point long been ignored, however, is that both the Shenzhen and Shanghai Stock Connects are closed-loop systems, which cannot lead to capital flight from China market, Li said.

Under the share trading schemes, mainland investors can exchange their yuan into Hong Kong dollars in the offshore market, which is only allowed to buy and sell eligible Hong Kong stocks under the scheme. The money must be exchanged back into yuan in their mainland account.

The yuan-in, yuan-out system avoids capital flight, but helps hedge the depreciation risk of the currency.

“That’s why the Chinese government is supportive of the Stock Connect schemes even though it is very cautious about capital flight,” Yao said.

“The mainland market currently lacks investable assets, and the Stock Connect solves the problem. It improves mainlanders’ asset diversification without leading to capital outflow.”

To avoid sharp capital exodus amid the continued weakness in the Chinese yuan, the government has been narrowing the gateways that help mainland money flow abroad.

The US$90 billion aggregate quota for Qualified Domestic Institutional Investors (QDII) was fully used up by March 2015, but officials are yet to increase the quota, according to Sina Weibo posted by State Administration of Foreign Exchange.

QDII is a channel for mainland institutions, such as fund managers, exchanging yuan into US dollars and investing in foreign assets outside of the mainland.

“I don’t expect a big increase in the QDII quota in near term, because the system doesn’t ensure money flows back,” Yao said.

On October 30, state-backed China UnionPay Co banned customers from buying investment-related insurance products in Hong Kong, another move to curb sizable money flow.

Winner Lee, executive director and Asia equity derivatives strategist at BNP Paribas, said besides currency movements, Hong Kong stocks are attractive due to cheap valuations.

The Hang Seng China AH Premium Index declined from its peak of around 140 in mid-May to about 121 currently thanks to a Hong Kong market boom after the Brexit vote in late June.

But that indicates mainland A-shares are still trading at about 21 per cent premium to corresponding H-shares in the city.

“Shenzhen stocks are traded at 31 times the P/E ratio, so Hong Kong’s small and mid caps look attractive due to cheap valuations,” she said, expecting more mainlanders to target stocks eligible in the Shenzhen trading link, which is expected to launch on November 21, even if they are China-asset backed.

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