April 11, 2018
Investors have been clamoring for access to China’s capital markets for decades. With China having overtaken the U.S. as the world’s largest economy last year (although the U.S. is still top in terms of gross domestic product, at $18.6 trillion), investors’ desire for exposure to mainland Chinese assets from both the long and short side has never been greater.
While China’s capitalist side roars, it is still a closed market compared to many other countries in the region. However, there are ways to access shares of Chinese firms listed on the Hong Kong and Shanghai equity exchanges.
Hong Kong H-shares
The Hong Kong securities lending market in its current form started back in December 1997 when the Central Moneymarkets Unit (CMU) launched a lending market for private sector debt. After extensive consultation with the market in March 2002, the Securities & Futures Ordinance (SFO) was enacted, providing a regulatory framework that is the foundation for today’s Hong Kong securities lending market. The Hong Kong market provides a flexible over-the-counter market that has steadily grown since then.
The Hong Kong equity market is broken into two primary security types: H-shares and Hong Kong shares. Hong Kong shares represent firms incorporated in a country other than China that trade on the Hong Kong Stock Exchange (HKEX), whereas the H-shares refer to shares of Chinese-incorporated companies that are traded on HKEX.
H-shares saw a significant increase in loan balances over 2017, rising from around 25.52% at the beginning of 2017 to around 60.30% of the Hong Kong market by close of 2017. This was driven in part by Ping An Insurance “H” (2318 HK), which had loan balances ending 2017 at $7.01 billion. While fees to borrow the insurance company are low, utilization in the stock steadily increased through last year, from 10% to 40% by the end of 2017.
The number of H-share securities on loan increased marginally from 155 to 164. The average on-loan balance of H-shares also increased during the same timeframe from $37.30 million to $44.80 million.
Automobile manufacturer BYD Company H-shares (1211 HK) continued to be the largest revenue earner in 2017, as in years past, bringing in an impressive $24.54 million. Capital Goods firm Xinjiang Goldwind Science & Technology (2208 HK) H-shares were also profitable, yielding $4.22 million in revenue last year.
Hong Kong Stock Connect
When viewing the Chinese market, there are essentially two market types: A and B share markets. China A-shares are Chinese securities traded on the Shanghai and Shenzhen exchanges that are denominated in renminbi, while B-shares are securities denominated in a foreign currency (U.S. dollars in Shanghai and Hong Kong dollars in Shenzhen). Historically the A-shares were open only to local participants and B-shares only to foreigners. That changed in 2001, when Chinese authorities relaxed the restrictions to open the B-share market to Chinese investors, and further in 2003, when a select number of foreign institutions were permitted to invest in A-shares.
Despite the size of China’s market, the lending market for onshore lenders in Shanghai-listed A-shares remains very limited. In order to facilitate short selling of eligible Shanghai-listed securities, the Shanghai-Hong Kong Stock Connect scheme (northbound trading) was introduced in November 2014; the Shenzhen-Hong Kong Connect followed in late 2016. Only A-shares are included, while security types such as B-shares, REITs and ETFs are excluded. Borrowing can only be facilitated via exchange participants or designated qualified institutions regulated under the SFC Ordinance on a principal basis, and lenders must be Hong Kong registered. The requirement for either registration in Hong Kong, or as an exchange member, has greatly impeded use by the offshore lending market. Hong Kong regulators are looking to implement an identification program for all Hong Kong investors seeking to buy A-shares using the Connect schemes. This will make participation more transparent, bring the territory in line with mainland requirements and hopefully open up participation.
Stock lending in Connect is subject to restrictions put in place by the Shenzhen and Shanghai exchanges. For instance, securities lending transactions for the purpose of short selling cannot be longer than one calendar month, and all securities lending activities must be reported to The Stock Exchange of Hong Kong.
With the MSCI inclusion of Chinese A-shares, the impact of moving assets away from existing lending markets may provide a reason for review, hopefully eventually allowing investors access to these in-demand securities. While securities lending rules may be unviable in their current form, development and change is headed in the right direction. As a result, it is not a case of if, but of when, securities lending will happen via the connection.