Geoff Lewis looks at the performance of the Hong Kong equity market and how growing links with China will affect it in the future
Many international investors have been surprised at the disappointing performance of the Hong Kong equity market this year, down 13.6% in the first six months. So far, there has been little sign of a strong liquidity-driven bounce in the Hang Seng on account of falling US interest rates.
The main opportunities for investors in the Hong Kong equity market in the next few years will arise from the growing links to China, and the major changes which this will have on the structure of the Hong Kong market.
In its quest for precious dollars to modernise and meet the challenge posed by the WTO, China will continue to showcase the best mainland enterprises to global investors via the stock market of Hong Kong. The recent flow of large-cap China IPOs to the Hong Kong market typified by companies like PetroChina, Sinopec, and China Mobile looks set to continue for a number of years to come.
The 2001 rally
Nothing is more illustrative of the growing importance of the 'China factor' to Hong Kong's financial system than this year's strong first-half rally in the H-share and red chip China-play stocks.* Their advance stands in marked contrast to the dismal performance of the domestic stock market as reflected by the Hang Seng Index (HSI).**
The H-Shang is well supported by China's strong economic fundamentals ' in our view, the best in Asia. Recent economic data for production, investment and retail sales shows clearly that China is weathering the slowdown in US export demand much better than other Asian economies.
The trigger for the rally in H-shares was Beijing's decision in February to grant domestic investors with foreign currency access to the B-share stock markets of Shanghai and Shenzhen. These relatively small markets had largely failed to take-off and develop, had become increasingly illiquid in recent years and were of only peripheral interest to foreign portfolio investors. In theory, the B-share markets ' with a combined market cap of only US$7bn prior to the February reform ' had until then been limited to foreign investors. In practice, mainland investors had always been active participants, as there were many ways for them to evade China's foreign exchange controls prohibiting them from owning B-shares. Periodic attempts to enforce the regulations were unsuccessful, and China brokers estimated that around 60-70% of B-share turnover was typically accounted for by mainland retail investors.
February's small but positive step towards unifying China's somewhat fragmented domestic equity markets led to an immediate flood of mainland money into B-shares, which in valuation terms stood at an initial 80% discount to their A-share equivalents, in a classic case of arbitrage. The result was that B-shares soared in price, going limit up each day for an extended period. The two B-share market indices are now up 140-170% year-to-date. Such startling windfall gains ' which demanded little in the way of investment expertise ' soon encouraged mainland investors to pour money also into Hong Kong's H-shares, where they could again easily evade the relatively ineffective capital controls.
They assumed that China's stock market regulatory body (CSRC) would within a year or two at most allow them to invest in H-shares also. While the illicit mainland inflows, that triggered the strong rally in China plays is admittedly speculative in nature, we do not think there is much danger of any sudden reversal. This is because (i) H-shares were in any case looking attractive in their own right, with CAGR of 25% forecast for earnings over the next three years, (ii) since H-shares stood on an average PE of 10x compared to 60x for A-shares, the potential arbitrage gains to patient mainland investors are enormous, and, lastly, (iii) Beijing has clearly signaled a firm intention to move to a more-unified structure for China's equity markets. That much is clear both from the B-share relaxation and in the CSRC allowing a growing number of H-share companies to tap the domestic market by also issuing A-shares.
China shares, then, are currently among the most actively traded stocks in the Hong Kong market, which has effectively become two-tiered. As noted above, China plays have been driven in part by black money inflows from the mainland. But of much greater fundamental importance than this, we have also seen a sea-change in the attitude of Hong Kong and overseas investors to H-shares and red chips that had its beginnings well before the influx of mainland liquidity.
There are still investor concerns, of course, over transparency, accounting standards, corporate governance and the relationships between H-share companies and their parent state-owned enterprises (SOEs) and government sponsors who still have considerable influence. Corporate governance was a particular problem for foreign investors in the early years of the H-share market's existence. Then, the erstwhile China bureaucrats who had become the new managers had little idea as to what shareholders or markets expected of them. But at a growing number of H-share companies, there have been some notable improvements in this area in the last year or two.
We regard the new-found attractions of Hong Kong-listed China stocks to mainland and international investors as being firmly based and we view the rally in Hong Kong China plays as having considerable room for further advance in the months ahead. Hence, any technical correction should be seen as a good opportunity for investors to enter the market and participate in the next stage of China's modernization. We strongly believe that over the next decade China will make a successful transition to a market economy.
Although the market cap of the 53 H-shares is still fairly small relative to the overall size of the Hong Kong market (about 8.5%, or HK$110bn, at end-June), we think it will continue to show dramatic growth in the years ahead.
So much so that five to 10 years from now the entire character of the Hong Kong stock market will have changed significantly. The traditional domestic stalwarts of banking and property will diminish greatly in importance, to be replaced by a much-expanded range of China companies, with more large cap issues such as Bank of China, Shanghai Airport and China Telecom already preparing themselves for launch.
We believe Beijing will continue to showcase the best mainland enterprises to global investors via Hong Kong. In addition, we think we will see many young private sector concerns led by China's new entrepreneurial class wanting to list in Hong Kong, both on GEM and the main board, thereby emphasising their capitalist credentials. Beijing will exercise little control over them.
A forecast recently published by local Hong Kong brokerage, South China Securities, shows the H-share market more than doubling in size within the next three years. The 24 prospective H-shares in the pipeline are expected to raise around US$27bn in total. Many of the prospective new entrants are already groomed and waiting in the wings.
Looking to the future, Hong Kong's financial sector will continue to benefit immensely from China's WTO-inspired economic renaissance. We expect Hong Kong to retain its role as the primary interface between mainland China and the global investment community. The SAR has a tremendous future as a key supplier of all kinds of business and financial services to a China that, in many cases, still lacks the 'software' of a modern economy. There will, of course, be growing competition from Shanghai. But it is becoming increasingly apparent that the real challenge to Hong Kong from Shanghai lies further into the future than was predicted by the majority of China-watchers at the time of the handover four years ago.
The main opportunities for investors in the Hong Kong equity market in the next few years will arise from the growing links to China.
China plays have been driven in part by black money inflows from the mainland.
Beijing will continue to showcase the best mainland enterprises to global investors via Hong Kong.
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