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Over the last few years, we have seen significant changes in the stock exchange landscape globally. Stock exchanges have demutualised and tried to focus on new sources of profits. There has been an increasing focus on winning business outside the home market. Exchanges, typically monopoly suppliers in the home market, had looked beyond traditional areas of business in order to try to grow returns for shareholders. One of these areas has been in seeking listing and trading from overseas companies.
The area of greatest focus recently has been on Chinese companies. As China has emerged as a market economy, companies, both state-owned and private, have sought to tap into the world<'s capital markets in order both to raise capital for future expansion and to raise standards of corporate governance, transparency, risk management etc.
Hong Kong has traditionally been the overseas market of choice for Chinese companies. This article looks at the extent to which this position has changed and its current standing against other world markets. I also examine some of the reforms currently underway in the Chinese market which are likely to affect the global position of Chinese companies going forward.
Terminology
H-share companies refer to companies incorporated in the People's Republic of China (PRC) and approved by the China Securities Regulatory Commission (CSRC) for a listing in Hong Kong. The par value of the shares is denominated in RMB, but the shares are subscribed for and traded in HKD or other currencies.
Red chip companies refer to companies where:
- at least 30% shareholding is held in aggregate by Chinese entities, and/or indirectly through companies controlled by them, with the Chinese entities being the single largest shareholders in aggregate terms; or
- the shareholding of the company held in aggregate directly and/or indirectly by Chinese entities is between 20 and 30% and there is a strong influential presence of Chinese-linked individuals on the company's board of directors. Chinese entities include state-owned enterprises (SOEs), and entities controlled by provincial and municipal authorities.
In the mainland, there are two classes of shares: A-shares and B-shares. A-shares are restricted to local mainland investors, whilst B-shares were originally open to foreign investors. However, since 2001, B-shares have also been opened to local mainland investors.
Hong Kong: A fund-raising centre for Chinese companies
In 2004 and 2005, the Hong Kong stock market was the fourth largest fund-raising market in the world and the largest in Asia. This is underpinned by the listings of Chinese companies. For instance, the total amount of funds raised by H-share companies in Hong Kong was USD18.9bn last year. This was higher than the USD4.1bn raised by the stock markets in China. In other words, the amount of funds raised by Chinese companies through the H-share market in Hong Kong was higher than that through the Chinese stock markets. In addition, the amount of funds raised by H-share companies in Hong Kong has been growing in recent years.
It is evident that Hong Kong is the key fund-raising centre and a preferred place for overseas listings of Chinese companies. According to the CSRC, 122 PRC-incorporated companies were listed on overseas exchanges at the end of 2005. Of these, 120 had a listing in Hong Kong as H-share companies. In addition, there were 89 red-chip companies and more than 120 Minying (i.e. privately-owned) companies listed in Hong Kong. Altogether, these Chinese companies accounted for about 40% of the total market cap and market turnover.
Therefore, the growth of our stock market mainly comes from Chinese companies, because our market has already reached a mature stage where most local companies - those which are eligible and wish to do so - have already been listed. China is reforming its state-owned enterprises (SOEs) on the one hand, and undertaking reforms in the stock market on the other. China needs an international stock market to provide a platform for its companies to raise funds and, more importantly, to enhance their corporate governance.
Hong Kong has a sound legal and regulatory framework, free flow of capital and information, and a critical mass of professionals and service-providers who adopt practices which are of international standards. Also, Hong Kong offers a broad investor base and international visibility. Indeed, the ten largest IPOs in Hong Kong were all for Chinese companies.
In addition, the secondary market of Chinese stocks in Hong Kong is very active and participated in by international institutional investors. An active secondary market is also one of the factors in underpinning a buoyant primary market.
Funds raised by the Chinese markets and H-shares of the Hong Kong market (USDbn)
Trading of Chinese stocks in Hong Kong, the UK and US
In terms of trading activities in the secondary market, the trading of Chinese stocks continues to concentrate in Hong Kong and such trading continues to be very active. At the end of December 2005, 34 Chinese stocks were traded in the three major markets, namely Hong Kong, the UK and US. The turnover of almost all these stocks was higher in Hong Kong than in the UK and US during 2005. By market share, 80% of the trading took place in Hong Kong, whilst the shares of the UK and US were 7% and 13% respectively. More importantly, the market share of Hong Kong increased from 77% in 2004 (UK 8% and US 15%).
Whilst the trading of Chinese stocks in Hong Kong has been growing at a faster pace than in the UK and US, their trading activities also grew more rapidly than other stock types in Hong Kong. During the first two months of 2006, the market turnover increased 73%, but the trading of Chinese stocks surged 111% over the same period. Chinese stocks currently account for some 40% of the market turnover, and such share is even higher than blue chips.
The strong interest in Chinese stocks is driven by the strong growth of the Chinese economy. The Chinese economy is now the fourth largest in the world. As the Chinese economy is still very much in a developing stage, this means that it has huge potential to develop further in the future. Any investor who wants to participate in this growth story while under the protection of a sound regulatory framework will naturally include Chinese stocks listed in Hong Kong in their portfolios.
Reflecting the growing importance of Chinese companies, the weighting of Chinese stocks by major international index compilers increased. For instance, the weighting of Chinese stocks (the majority are listed in Hong Kong) in the FTSE All-World Index rose from 0.25% at the end of 2004 to 0.31% at the end of 2005. The weighting gained 8 basis points to 0.39% at the end of February 2006. It is estimated that for every basis point increase in the weighting, around USD550m worth of funds will be allocated to the market. This means that within the first two months of 2006, an additional investment of some USD4.4bn had been allocated to Chinese stocks.
Summary of trading of Chinese stocks in Hong Kong the UK and US (USDbn)
| Hong Kong Number of stocks | Value (USDbn) | UK Share Value (USDbn) | US Share Value (USDbn) | Total Share Value (USDbn) | |
| 2003 | 30 | 71.4 | 76.3% 8.4 | 9.0% 13.8 | 14.7% 93.6 |
| 2004 | 32 | 136.0 | 76.6% 14.6 | 8.2% 27.1 | 15.2% 177.7 |
| 2005 | 34 | 133.5 | 79.6% 12.4 | 7.4% 21.8 | 13.0% 167.7 |
Sources: HKEx, LSE and Bloomberg
Market reforms in China and possible impact on Hong Kong
The share reform
The share reform aims at listing the non-tradable shares and thus aligning the management's incentive with all shareholders and the best interest of the companies, thus enhancing their corporate governance. Prior to the share reform, only about one-third of the shares listed on the two mainland exchanges are tradable. The remaining two-thirds of the shares are mainly state shares and legal person shares, and are non-tradable. Non-tradable shares owe their existence to the historical concern of authorities about the possible loss of control over listed companies if all shares were tradable.
Due to the existence of non-tradable shares, the interests of the major shareholders, the minority shareholders and the management do not always coincide. The major shareholders, i.e. the state, may need to achieve certain policy objectives, which may not be in the interests of the minority shareholders. Management may also act to maximise their personal interests, rather than the interests of shareholders.
By listing the non-tradable shares, it is hoped that the management of listed companies will act for the best interests of the full set of shareholders. Also, by selling the state shares, it is hoped that the dual role of the state as the regulator and as the major shareholder will come to an end. This will help improve corporate governance and may enhance investor confidence.
The share reform in China started in the middle of last year (2005). No IPOs were allowed in mainland China and hence Hong Kong's role as the major market for Chinese companies to raise capital was strengthened. When the share reform is largely complete, the role of Hong Kong as a fund-raising centre may be affected. Moreover, some expressed concern that overseas listings of SOEs had created a 'loss' of state assets and that quality companies should also be listed in China. One major concern is that many of the country's best-regarded companies are listed only on overseas exchanges. Domestic investors are not able to invest in these companies given the foreign exchange control and cannot enjoy the profits following the IPOs. Moreover, Chinese companies do not in general lack access to capital - there is a very strong savings culture in China which has created a large pool of domestic capital.
One also needs to realise the strength of Hong Kong - in terms of flexibility of the economy, entrepreneurism and workforce. Because of such flexibility, the Hong Kong market has been benefiting from the reforms carried out in China. For instance, in 1993, when China started to reform its SOEs by listing them on overseas exchanges, Hong Kong benefited because these SOEs were listed in Hong Kong as H-shares.
Moreover, the close relationship between China and Hong Kong in political, economic, social and cultural dimensions puts us in a position to better understand the Chinese market. Our advantage niche is not only openness to the world, but also our expertise and professionalism in China as well as the connections built up there. Hong Kong is in the same time zone as China, which, together with the free flow of information, makes the market better able to offer investors timely information and therefore attract a broader investor base. Overseas investors, pre-dominantly institutional investors, contributed 36% to the total trading activities. This helps enrich the international visibility of companies listed in Hong Kong.
Given the advantages of Hong Kong and the need for Chinese companies to list on overseas exchanges, Hong Kong should be able to maintain its centre for overseas listings of Chinese companies. As far as Chinese companies are concerned, they also want to enhance their corporate governance and to get familiar with international practices. Companies that want to tap into the Chinese stock market because of a potentially higher P/E ratio will give more weight to other factors such as a broader investor base and free flow of information. To the extent that Chinese companies want to have international visibility and enhance their corporate governance, Hong Kong will continue to be the desired place for their listings.
Upon completion of the reform, the shareholding structure of Chinese companies becomes more similar to overseas listed companies. Therefore, it is likely to attract more interest from international investors. If overseas demand for Chinese stocks increases, there is no reason why such Chinese stocks have to be listed in China only. When these Chinese stocks plan to list overseas, Hong Kong should still be the preferred place of listing.
The qualified domestic institutional investors (QDII) scheme
If Chinese companies do not need to raise funds overseas because of abundant capital, this is a very strong reason for the Chinese Government to speed up the implementation of the qualified domestic institutional investors (QDII) scheme. Other reasons for implementing the QDII scheme are:
- Diversification - Investing overseas will allow funds to diversify their portfolios so as to minimise risks.
- A more balanced two-way flow of capital - There has been net capital inflow into China. With the implementation of the Qualified Foreign Institutional Investors (QFII) scheme in late 2002, the imbalance is even more tilted. The QDII scheme will therefore create a more balanced flow of capital.
- As a training ground for Chinese investors - The development of capital markets in China depends, among other factors, on the quality of Chinese investors. Through participating in overseas markets, Chinese investors will become familiar with the operations of developed markets and international practices.
- Convergence with international practices and raising the regulatory framework in China - As investors take part in other major developed overseas markets, they tend to bring in such practices and the more sophisticated regulatory framework. This will help speed up the overall development of capital markets.
One very important concern regarding the implementation of the QDII scheme is the possible impact on the Chinese stock markets. It is perceived that if funds are allowed to invest overseas, they will move out quickly. It should be noted that the Chinese markets do not usually lack capital and the gradual implementation of the QDII scheme should not significantly dampen the stock markets in the long term. Indeed, the implementation will demonstrate the authorities' determination to reform the capital markets. This may even help rebuild investors' confidence. As a matter of fact, certain insurance companies have been allowed to invest in overseas companies.
The QDII scheme means that as well as being the centre for overseas listings of Chinese companies, Hong Kong can strengthen its role as an international financial centre by assisting Chinese investors to invest overseas. For instance, with the benefit of an established derivative market in Hong Kong, market participants can design principal-guaranteed structured products to satisfy the needs of Chinese investors. They can also develop fixed income securities and mutual funds to broaden the variety of products available for investment. Therefore, with continuous financial innovation, Hong Kong should be able to meet the needs of Chinese investors and serve them as a centre for providing such services as asset management, financial planning, legal advice and research support.
The convergence of prices of A- and H-shares: experience and implications of the market reform
Despite the close relationship between mainland China and Hong Kong, the stock markets in Hong Kong and China are segregated. Owing to different demand -supply conditions, even for the same companies, share prices in the Chinese markets (A-shares) can be substantially higher than those in the Hong Kong market (H-shares), implying that A-shares are trading at high premiums over their H-share counterparts. Among other factors, such high premiums are due to:
- limited supply of A-shares - about one-third of the shares are tradable whilst the remaining two-thirds are non-tradable; and
- limited investment opportunities in China - In China, financial investment in overseas markets is controlled, whilst local investment opportunities are still limited. Savings were more than 10 times the tradable market cap of the Chinese markets.
With the rapid growth of the economy and wealth accumulation alongside limited investment opportunities in China, funds might have been channelled to the local stock markets, driving them to relatively high levels. However, the above factors seemed to have changed. First, the Chinese authorities started the share reform last year (2005). Prior to this, it was known that there were plans for the reform as early as 2001. In anticipation of an increase in the supply of shares, the markets seemed to have factored in such a change and made some corrections since then. Second, whilst the investment channels in China remain limited, there have been some relaxations to overseas investment: the relaxation over some insurance companies' investment overseas is a case in point. As the markets become more open, they converge towards international prices.
The premiums of A-shares over H-shares narrowed from a weighted average of 830% at the end of 2000 to 22% at the end of 2005. At the end of 2000, all A-shares were traded at very high premiums over their H-share counterparts. In contrast, at the end of 2005 most stocks were traded at much lower premiums (some even at discounts) over their H-share counterparts. Between the end of 2000 and the end of 2005, the benchmark indices in China dropped by some 50%, while the H-share index in Hong Kong rallied 228%.
With the share reform and the implementation of the QDII scheme, the convergence of the prices of A-shares and H-shares is likely to continue. It is expected that with a more open market, share prices on the Chinese stock markets are less affected by its domestic demand and supply conditions, but are more in line with international trends. Share prices are more capable of reflecting the fundamentals of the companies. The challenge is that Hong Kong needs to re-position itself in order to better serve Chinese companies in the future.
Performance of HSI (H-share Index) and A-Market indices (end 2000=100)
Conclusion
The Hong Kong stock market has been benefiting from the continuous development of China. In due course, we will support Chinese companies in terms of fund-raising and serve as a platform for them to get familiar with international practices. The result is a win-win situation for both China and Hong Kong.
Nevertheless, no market can withstand the dynamic environment by relying on its own static strengths. We need to capitalise on our strengths and better position Hong Kong in such a dynamic world. We need to further strengthen the regulatory regime and develop the financial infrastructure so as to ensure a fair, open, efficient and transparent market, participated in by professionals and investors coming from different markets and all sorts of professions. We also need to maintain our flexibility and enhance our knowledge in China so as to face different sorts of challenges and turn them into opportunities.
Whilst a sound and healthy regulatory regime can provide the necessary confidence to market participants, the depth of our market is one of the keys to absorb any emerging shocks. Therefore, our market has to develop a wider range of products so that investors can better manage the risks of their investments. A wider range of financial products not only provides tools for better risk management, but also serves the needs of Chinese investors and creates opportunities in other areas such as asset management and financial planning. With a broader coverage of products and services, we deepen our markets, attracting investors from the rest of the world and withstanding the competition from the markets in the region.
