It’s been a long time coming, but last week China’s State Council finally signed off on the Shenzhen-Hong Kong Connect initiative that will let non-mainland investors buy and sell shares listed on the Shenzhen Stock Exchange. What’s more, mainland regulators scrapped the upper limit on shares offshore investors can hold through the two-year old Shanghai-Hong Kong Connect, and said Shenzhen would have no such ceiling. A daily throttle will still limit the pace of purchases, but in effect Beijing has just thrown its jealously-guarded domestic A-share market fully open to foreign investors.
Whether foreigners will be interested is another matter, and the precedent is hardly encouraging. Under the Shanghai-Hong Kong Connect deal, they have been allowed up to 300 billion yuan of Shanghai-listed A-shares. As of the middle of last week, they owned just 143 billion yuan – less than half their allotted quota.
Foreign investors’ coolness towards Shanghai stocks is unsurprising. The Shanghai market is dominated by state-owned enterprises. The biggest single sector consists of heavy industrial companies – coal miners, metal-bashers, and the like – which together make up 32 per cent of the Shanghai A-share index. These are the companies that have been hit hardest by China’s economic slowdown. Suffering grievous over-capacity and facing a long, painful downsizing, they have little to attract foreign investors.
The second biggest segment of the market, at 29 per cent by capitalisation, is made up of financial companies, principally China’s big state-owned banks. After years of reckless lending to support state industries, these have been left on a mountain of largely unrecognised non-performing assets and are in dire need of recapitalisation; again, hardly an enticing prospect.
In any case, if foreign investors wanted exposure to Chinese energy companies or banks, they would find many of them listed in Hong Kong, and cheaper than in Shanghai. Where Chinese companies have both mainland A-share and Hong Kong H-share listings, as of last week the A-shares were on average 26 per cent more expensive. That’s considerably less than the 40 per cent premium A-shares sported at the end of last year, but even so, it’s not exactly appetising.
Hong Kong’s brokers, and no doubt mainland financiers too, are hoping Shenzhen will prove more attractive to international investors. While Shanghai is characterised by stodgy old state sector industrial companies, Shenzhen is the listing venue of choice for technology-focused private sector enterprises serving China’s fast-growing consumer market. For example, whereas health care and software services companies make up less than 2 per cent of Shanghai’s A-share index, they are more than 9 per cent per cent of Shenzhen’s main board by capitalisation. And with the exception of giants like Tencent, few such companies have offshore listings. Shenzhen offers hundreds.
But mainland investors have already bid up the Shenzhen market with impressive enthusiasm. Weighted for capitalisation, Shenzhen-listed A-shares are trading at a price-earnings ratio of 47. That means even if Shenzhen companies gave all their profits to investors in dividends, at present levels of profitability it would take 47 years for shareholders to break even. Admittedly, many companies in Shenzhen are expected to show robust profit growth over the coming years. But even so, as the chart shows, the Shenzhen market is at nosebleed valuations compared with Shanghai, which is on a price-earnings ratio of 17, and the Hong Kong H-share index.
As a result, offshore interest in buying mainland shares through the new connect is likely to be lukewarm at best. Some hope that will change if scrapping the ceilings on foreign holdings paves the way for the inclusion of mainland A-share markets in MSCI’s equity indices. With the Shanghai and Shenzhen markets together worth a thumping 49 trillion yuan, and some US$1.7 trillion of international institutional funds managed against MSCI’s emerging markets index, bullish investors have forecast a tidal wave into the A-share market following inclusion.
They are overly optimistic. Regulators may have ditched the quota on holdings through the connect system, but they still impose a foreign ownership limit of 30 per cent of domestically-listed companies’ freely floating shares. In its turn, MSCI has said it will only include mainland companies in its indexes at a weighting of 5 per cent of that limit. As a result, the likely inflows into A-shares following their inclusion will amount to less than US$20 billion. That’s scarcely more than 10 per cent of the Shenzhen market’s average daily turnover.
If offshore investors are unlikely to be fired up by the chance to buy Shenzhen shares, it’s doubtful whether mainland investors will be any more enthusiastic about the reciprocal arrangement that will allow them to buy additional stocks in Hong Kong.
Even though Hong Kong stocks trade at a considerable discount to their Shanghai counterparts, mainland investors have consistently failed to take up their full permitted allocation.
It’s hard to see how the chance to buy a few extra Hong Kong stocks will make a significant difference.
Tom Holland is a former South China Morning Post staffer who has been writing about Asian affairs for 20 years.