Where Is the "Hong Kong Stock Express," Burdened with a Regulatory Mission, Heading?

Author: [Mu Zi]
Source: [Fund Analysis]
Article type: Regular article
Published: 2007-8-31 19:58:12
Column: Expert Perspectives

Recently, the "Hong Kong Stock Express" pilot program has attracted wide investor attention. As China's capital market develops, the pathways for Chinese investors to participate in any capital market worldwide will become increasingly convenient. Individual direct participation in Hong Kong stocks is merely a small overture. The practical problem is that this perfectly normal "Hong Kong Stock Express" has been intentionally or unintentionally burdened with a regulatory mission it should never have to carry — using the "Hong Kong Stock Express" to engineer an A-share soft landing has somehow become a regulatory wonder-drug. Supposedly, this wonder-drug can also cure excess liquidity, serving as a two-birds-one-stone solution for both liquidity surplus and stock market bubbles.

All theories that transmute the "Hong Kong Stock Express" into a cure-all miracle drug rest on the following assumption: the huge price gap between stocks listed on both A-shares and Hong Kong is irrational. In fact, this is nothing more than a not-very-clever misreading. This misreading is built on the following erroneous belief: for example, with China Life, whether traded on A-shares or in Hong Kong, it is the same company, so the per-share price should be the same. But as the saying goes, oranges grown south of the Huai River turn into bitter trifoliate oranges when planted north of it. In the market, the only thing that can be assessed is transactional value, which is the resultant of numerous market factors. China Life A-shares having a different price in Hong Kong is actually the most normal thing in the world.

Let's use the simplest model to evaluate the transactional value of the same stock in different markets: let the total tradable market capitalization in each market represent the same company. Correspondingly, we can establish a valuation model based on the principle that the total tradable market cap of the same stock must be equal across different markets.

For example, for China Life, listed on both A-shares and Hong Kong: A-share price x A-share float = Hong Kong price x Hong Kong float. Currently, China Life's A-share float is only one-fifth of its Hong Kong float. Therefore, even if the A-share price is five times the Hong Kong price, there is nothing irrational about it. In fact, the price difference between the two doesn't even reach one-fold.

From another perspective, since the Hong Kong dollar is pegged to the U.S. dollar, Hong Kong dollar assets naturally don't preserve value as well as RMB assets against the backdrop of RMB appreciation. And Hong Kong's interest rates are much higher than mainland rates, so the acceptable P/E ratio naturally should be much lower than for A-shares. Therefore, the same stock commanding a much higher transactional value on A-shares than in Hong Kong is perfectly rational.

From all this, it is clear that the notion that the same stock should trade at the same price everywhere in the world is incredibly naive and laughable. It can be asserted that even with the same group of traders trading the same stock in different markets, the trading prices would not be the same. For example, facing a Hong Kong float of China Life that is five times larger, the price — even for the same group of traders — would obviously be far below the A-share price. Therefore, the naive idea that the "Hong Kong Stock Express" can equalize stock prices across the two markets is extremely laughable. Unless all the fundamental market variables between A-shares and Hong Kong are adjusted to be basically identical, this "Hong Kong Stock Express," burdened with its regulatory mission, is destined not to head in the direction its mission prescribes.

In truth, the crux of the A-share problem is extremely obvious and can be solved without any form of express train. In the model analysis above, simply replace "Hong Kong stocks" with "regulation-compliant A-shares." To achieve lower, more reasonable P/E ratio trading for the regulation-compliant A-shares, the simplest method is to increase the float. For example, China Life currently has only 1.5 billion A-share float; if changed to 7.5 billion, the trading price obviously could not be what it is now.

The crux of the problem further lies in the fact that the so-called "Pretty 50" or large-cap blue chips currently being heavily pumped up are, from the standpoint of the Securities Law, suspected of illegality. The Securities Law stipulates: "Companies with total share capital exceeding 400 million yuan must have at least 10% publicly issued shares." Thus, China Life's A-share float should be at least 2.8 billion, not the current 1.5 billion including unlisted strategic allocations. This is a universal phenomenon among all large-cap blue chips, and it is precisely a non-negligible factor enabling first-tier blue chips to be so easily bubblified.

Without a reasonable float, there can be no reasonable price. The solution to the blue-chip supply shortage should start with strict enforcement of the Securities Law — ensuring publicly issued share ratios reach the 10% minimum. Some may say that publicly issued shares include H-shares. If so, then that provision needs amendment — it should be explicitly revised to require at least 10% of publicly issued shares to be A-shares. Otherwise, each new ultra-low-float blue-chip IPO only adds another instrument for leveraged speculation. With index futures imminent, this point is especially critical.

From the standpoint of the capital market's long-term historical development, domestic capital is not too much but too little. This precious capital should be retained in A-shares. We can't complain about too much water in the rainy season and too little in the dry season — what's the point of a reservoir then? If China's capital market has weak water-storage capacity, you can't blame the water. You should find ways to quickly upgrade the reservoir to meet the needs of economic development — that is the practical and proper thing to do. Otherwise, to divert water outside as a short-term fix — the medicine obtained from such panicked remedy-seeking has truly slim chances of becoming a miracle cure.

(Special Senior Advisor to this publication, Mu Zi)