Asia

Investing in China is about to get easier

China has a carefully managed plan to open its doors to ever greater inflows and outflows of investment capital. Since China is already the world’s second largest economy by some measures, and therefore the potential amounts of capital involved are vast, this process is essential for all investors to know about. Next week a key step in the plan will add a further important link between the Hong Kong and Shanghai stock exchanges. This will make it much easier for foreigners to invest in the mainland stock market.

Due to protests on the streets, Hong Kong has featured prominently in the news headlines in recent weeks. The territory was a British colony until 1997, when it returned to Chinese administration. Many people there want to change the political system, so that it’s more democratic.

But China isn’t a democratic country, at least as usually understood. So the issue is a sensitive one. The government in Beijing is now offering three pre-approved candidates to be put forward in elections to the post of “Chief Executive” in 2017. (By the way, isn’t that an oddly corporate title for a political bureaucrat approved by a supposedly Communist state?)

“Not good enough”, say the protestors, no doubt egged on by external influences. They want Hong Kong to be able to choose its own candidates. And so they’ve been blocking the streets, and waving around their yellow ribbons and umbrellas. A brightly coloured and high profile thorn in the side of the authorities to the north.

Ironically, what China is offering is far more democratic than when Britain was in charge as recently as 17 years ago. In those days a colonial governor was appointed by the British government in London, and the Hong Kong Chinese had no say in the matter at all.

Politics aside, it’s been a reminder that Hong Kong is administered by China under a “one country, two systems” structure. Mainland China has one set of rules for political administration, the system of law, business regulation, taxes, currency and so on.

The territory of Hong Kong has a totally different set of rules. For example the legal system is still based on British law. However taxes are distinctly un-British: the top personal income tax rate is 17% (versus 45% in the UK) and there’s no capital gains tax on most things (up to 28% in Britain….on most things).

Also it’s much easier to set up a business in Hong Kong than on the mainland. Plus business regulation is light, the Hong Kong dollar is pegged to the US dollar for practical purposes and so on. They even drive on the left side of the road in Hong Kong, just as in Britain.

In fact, for ease of doing business, the World Bank ranks Hong Kong 3rd out of 189 countries and territories in the world (You can read more about ease of doing business here). That puts it behind only Singapore and New Zealand. By contrast, mainland China comes in at 90th place, just above Serbia and Paraguay. (By the way, I think these kinds of rankings are pretty biased towards narrow Western views of how things “should” be done. But that doesn’t mean they have no value at all.)

The idea of “one country, two systems” extends to the stock markets as well. It’s easy to become confused by the bewildering range of share types in China. I don’t want to go into too much detail, but some of the main categories are “red chips”, “h-shares”, “a-shares” and “b-shares”.

Some trade only on the mainland stock exchanges in Shanghai and Shenzhen. Others only trade in Hong Kong, under different exchange rules and “listing requirements”, which are the regulations for information disclosure and such like. And some companies have shares trading both on the mainland, and priced in renminbi yuan, and in Hong Kong, priced in Hong Kong dollars.

…I lived in Hong Kong a decade ago. I was working for a huge international investment bank and wealth manager called UBS…I had been tasked with coordinating the expansion of all the bank’s businesses in mainland China, which were tiny at the time.

I had to get my head around all this when I lived in Hong Kong a decade ago. I was working for a huge international investment bank and wealth manager called UBS, headquartered in Switzerland but with offices all over the world, including a big operation in Asia. Amongst other things, I had been tasked with coordinating the expansion of all the bank’s businesses in mainland China, which were tiny at the time.

To this day I’m still proud that, as part of the overall strategy, UBS was the very first foreign outfit to be allowed to trade a share on a mainland stock exchange. This was under a scheme called the “qualified foreign institutional investor”, or “QFII” scheme. UBS was awarded the first ever QFII licence.

QFII operated a quota system. Investment banks and fund managers could apply, and if they convinced the Chinese regulators that they would act responsibly they were awarded a quota. The quota set the maximum amount of money that they could put into the market, and varied by institution. Good relationships with the regulators helped with getting bigger quotas. UBS was awarded the largest initial quota, as well as the first licence.

There was no other way than QFII for a foreigner to get direct access to the domestic Chinese stock (or bond) markets. The only route in was by buying stocks of Chinese companies that were listed in Hong Kong. This narrowed the potential field considerably.

A lot has happened in the past decade in China, and no doubt the finer points of the QFII regulations have changed. These days there are more institutions with QFII licences, and the individual quotas are much bigger than the original amounts in many cases. The total QFII scheme has grown to the equivalent of $64 billion according to Bloomberg, a financial news service, from just $200 million when UBS won the first licence. But how much money has been allowed in, and from whom, has remained tightly controlled by the QFII system.

Until now.

China has just given the green light for something called the “Shanghai-Hong Kong stock connect”. This will make it much easier for foreign investors to buy and sell shares in Shanghai and for mainland Chinese investors to buy and sell shares in Hong Kong.

China has just given the green light for something called the “Shanghai-Hong Kong stock connect”. This will make it much easier for foreign investors to buy and sell shares in Shanghai and for mainland Chinese investors to buy and sell shares in Hong Kong. It will go live next week.

But this won’t be a free-for-all. There will still be limits, at least for the time being. Remember, this is part of a carefully managed overall plan to free up capital flows into and out of China. One step at a time.

As with most reforms, financial or otherwise, the Chinese government is known for trying things out on a small scale first. Once they are comfortable, or have made the necessary adjustments to the original policy, then – and only then – do they increase the scale.

Initially the total flows will be limited to 300 billion yuan (equivalent to US$49 billion) heading north into the mainland, and 250 billion renminbi yuan (US$41 billion) heading south into Hong Kong. Plus there will be maximum daily trading volumes. Foreign investors will be able to buy shares of 568 companies listed in Shanghai and Chinese investors to buy 268 shares listed in Hong Kong.

This represents only a small part of each market that has been opened up, in relation to total market size. In total, according to the World Federation of Exchanges, shares of 980 companies traded in Shanghai at the end of October and 1,729 in Hong Kong.

Shanghai had a market capitalisation of US$3.0 trillion and Hong Kong US$3.3 trillion at the end of last month. To put that into perspective, the London Stock Exchange, which was founded in the year 1801, had a market capitalisation of US$4.1 trillion at the end of October. (Market capitalisation, or “market cap”, is the number of shares listed multiplied by the market price of those shares.)

And so far the Shenzhen stock exchange – China’s other big exchange – isn’t included in the arrangement. Shenzhen had 1,604 companies listed with a value of US$2.0 trillion at the end of October.

…the point is that it’s another move along the multi-decade track of China’s opening up to the world, and specifically to its investment capital flows.

But the point is that it’s another move along the multi-decade track of China’s opening up to the world, and specifically to its investment capital flows. This is a two way street, with ever increasing amounts of money being allowed to cross the border in both directions.

The amounts to be permitted in future remain unknown. And the timing of future reforms and relaxations will always be unpredictable. But this is a huge trend that all investors should be aware of. Keep your eyes open to news stories about further developments in the management of China’s capital account, which is still closely controlled.

Never before have such vast amounts of capital been progressively allowed to cross political borders after so many decades of tight restrictions. This will have large and wide reaching implications for investors everywhere. The eventual amounts could run into the equivalent of trillions of US dollars, and maybe tens of trillions.

This is all part of the bigger picture of China’s ever growing influence in the world. One day, decades from now, China’s currency may even challenge the mighty US dollar as the world’s trade and reserve currency of choice (I discussed this important trend in previous articles. See here and here for more).

But, for now – and as globally minded investors – we should be happy to see this huge and increasingly prosperous country open the door another crack to foreigners. Investing in China is about to get easier.

Stay tuned OfWealthers,

Rob Marstrand
robmarstrand@ofwealth.com

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Rob is the founder of OfWealth, a service that aims to explain to private investors, in simple terms, how to maximise their investment success in world markets. Before that he spent 15 years working for investment bank UBS, the world’s largest wealth manager and stock trader with headquarters in Switzerland. During that time he was based in London, Zurich and Hong Kong and worked in many countries, especially throughout Asia. After that he was Chief Investment Strategist for the Bonner & Partners Family Office for four years, a project set up by Agora founder Bill Bonner that focuses on successful inter-generational wealth transfer and long term investment. Rob has lived in Buenos Aires, Argentina for the past eight years, which is the perfect place to learn about financial crises.