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The Unbearable Mission of the "Hong Kong Stock Connect"

2007/9/24 8:52:17

Recently, the "Hong Kong Stock Connect" pilot program has attracted the attention of the investing public. As China's capital market undergoes massive development, Chinese investors will find it increasingly convenient to participate in any capital market in the world. Direct individual participation in Hong Kong stocks is merely a small prelude. The practical problem is that this perfectly normal "Hong Kong Stock Connect" has, intentionally or not, been burdened with a regulatory mission it should never have carried. Using the "Hong Kong Stock Connect" to engineer a soft landing for A-shares has somehow become a masterstroke of regulation. Supposedly, this miracle cure can also fix excess liquidity—a single arrow hitting two hawks: solving both liquidity surplus and stock market bubbles.

All the brilliant theories that have alchemized the "Hong Kong Stock Connect" into a cure-all share the same assumption: the huge price gap between stocks dual-listed on A-shares and Hong Kong is unreasonable. In reality, this is nothing more than a rather unsophisticated misreading. This misreading rests on the flawed premise that, take China Life as an example, since it's the same company whether traded on A-shares or in Hong Kong, the per-share price should be identical. But oranges south of the Huai River become trifoliate when planted north of it. In markets, the only thing that can be assessed is the transactional value, which is compositely determined by numerous market factors. That A-share China Life commands a different price in Hong Kong is, in fact, the most normal thing in the world.

Let's use a simple model to evaluate the transactional value of the same instrument across different markets: represent the same company by the total tradeable market capitalization in each market. Accordingly, one can build a value analysis model based on the premise that the total tradeable market cap of the same instrument must be equal across different markets.

For example, for China Life, which is traded on both A-shares and Hong Kong, we have: A-share price × A-share float = Hong Kong price × 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 5 times the Hong Kong price, there is nothing unreasonable about it whatsoever. And in fact, the price differential between the two isn't even 1x.

From another perspective, since the Hong Kong dollar is pegged to the US dollar, under the broad backdrop of RMB appreciation, HKD-denominated assets naturally don't preserve value as well as RMB-denominated assets. Moreover, HKD interest rates are much higher than RMB rates, so the acceptable fair P/E ratio is naturally much lower than for A-shares. Therefore, it is entirely rational for the same instrument to command a much higher transactional value on A-shares than in Hong Kong.

From all this, it's clear that the notion that the same stock should trade at identical prices anywhere in the world is incredibly naive and laughable. One can say with certainty that even if the exact same group of traders were trading the same instrument in different markets, the transaction prices would not be the same. For instance, facing a Hong Kong float of China Life that is five times larger, the price—even if traded by the exact same people—would obviously be far lower than on A-shares. Therefore, the naive fantasy that the "Hong Kong Stock Connect" can equalize stock prices across the two markets is utterly absurd. Unless all the underlying market variables between A-shares and Hong Kong are adjusted to be essentially identical, this regulation-burdened "Hong Kong Stock Connect" is destined to not connect directly toward its mandated destination.

In fact, the crux of A-shares' problems is glaringly obvious and requires no form of "connect" whatsoever to resolve. In the model analysis above, simply replace Hong Kong with a regulation-compliant A-share market. In such a regulation-compliant A-share market, if one wishes for stock prices to trade in a more reasonable, lower-P/E environment, the simplest method is to increase the float. For example, if China Life's current A-share float of only 1.5 billion shares were increased to 7.5 billion, its trading price obviously could not remain at current levels.

The critical point is this: the so-called "Nifty Fifty" or large-cap blue chips currently being massively pumped up are, from the perspective of the Securities Law, all suspects of illegality. The Securities Law stipulates that "for companies with total share capital exceeding RMB 400 million, the publicly issued share ratio must be 10% or above." Accordingly, China Life's A-share float should be at least 2.8 billion shares, not the current 1.5 billion including the yet-unlisted strategic allotments. This is a widespread phenomenon across all large-cap blue chips, and it is precisely a factor that cannot be ignored in enabling front-line blue chips to be so easily bubbled up.

Without reasonable float, there can be no reasonable prices. The current blue-chip supply shortage should be addressed first by strictly enforcing the Securities Law and ensuring the publicly issued share ratio reaches the 10% standard. Some may argue that publicly issued shares include H-shares. If so, then this provision needs amendment—it should be explicitly revised to require that the publicly issued share ratio on A-shares alone must be 10% or above. Otherwise, newly listed ultra-low-float blue chips will merely add more instruments for leveraged speculation. With stock index futures imminent, this point is especially critical.

From the perspective of the historical development of capital markets, domestic capital is not too much—it's too little. These precious funds should remain in A-shares. You can't complain about too much water during the rainy season and too little during the drought—then what's the reservoir for? If China's capital market has weak water-retention capacity, don't blame the water—blame the reservoir for not being up to standard. The right approach is to find every possible way to quickly build the reservoir to meet the needs of economic development. That's practical, that's the real work. Otherwise, constantly diverting water outside to relieve immediate pressure—this doctor-shopping-in-a-panic prescription has vanishingly slim chances of becoming a miracle cure.