Equities: Mainland China for foreign institutions
Efforts are being made to attract more foreign investment in Chinese stock markets
• The Stock Connect channel is becoming the most popular way for foreign investors to get access to the Chinese domestic stock market.
• Global fund houses are setting up research capabilities in Beijing, Shanghai and Shenzhen.
• Conservative institutions remain concerned about transparency, state interference and poor corporate governance.
• Corporate governance is improving but many Chinese companies have little awareness of environmental, social and governance issues.
Up to now most foreign institutions have gained exposure to mainland China through a Qualified Foreign Institutional Investor (QFII) quota, strictly controlled by China’s State Administration of Foreign Exchange (SAFE). More recently, with greater scope for investment and fewer restrictions on capital repatriation, the RMB Qualified Foreign Institutional Investor (RQFII) programme has soaked up further demand for exposure to mainland China.
New investors in China are more likely to use the Stock Connect channel, which has been in place since November 2014, initially connecting Shanghai with Hong Kong, and with Shenzhen coming on stream in 2016.
Stock Connect is widely considered the most convenient way for investors to access China’s mainland stocks. However, it does not allow access to all stocks – in Shanghai it is just over 500 and in Shenzhen about 800 stocks, out of a total of 3,000 stocks – but there are no limits on individual investment or quotas. Dealing is daily and trading can be done through a brokerage in Hong Kong.
Although access via Stock Connect is limited to the larger caps, investors can get access to 70-80% of the market. At this point though, most of the investment on the Stock Connect platform is flowing south from China to Hong Kong, accounting for about 17% of the total turnover in the Hong Kong market.
The reasons for this relative lack of take-up by foreign investment go to the heart of the challenge for China in integrating its markets into the global system, in synchronising regulation, technology and cultural norms.
Refinement of the Stock Connect rules, with the elimination of the annual aggregate quota for trading through Shanghai and Hong Kong, for example, is expected to encourage more investors to participate. Capital controls under QFII are also about to be lifted, it is rumoured. While the MSCI index inclusion is a spur for investors to engage with the mainland, we are still much closer to the start than the end of this process.
Caroline Yu, head of greater China equities at BNP Paribas Asset Management, notes that global fund houses are setting up research capabilities in Shanghai, Beijing and Shenzhen on the expectation of the 5% MSCI inclusion factor expanding. “That process is now irreversible, and given that a lot of new names are coming into the investor universe, it will take time to ramp up the coverage of a lot of the stocks that are relatively unknown to foreign portfolio managers,” says Yu.
Foreign participation in the local market is less than 2% of buying, but the view is that over the longer term the domestic (and predominantly retail) investor base structure of China’s stock markets will change.
In the meantime, global investors have other options when it comes to China. Hong Kong-listed China plays are now plentiful and US investors are often content to buy local American Depositary Receipts (ADRs) for their China exposure.
The offshore China markets, both Hong Kong listed shares and US ADRs, have performed well this year. The sector is getting more attention and fund managers have reported that more money is being allocated to China overall. The discount between A and H shares – which was one of the drivers of southbound flows – has reduced, if only slightly.
In Hong Kong, there are about 180 stocks which are dual-listed (A and H) and the average discount is still quite wide. There are also stocks with no equivalent in China, such as high-end property owners, luxury brands, Macau gaming operations and some of the IT names that are not available in China.
Ricky Chau, multi-asset portfolio manager at Franklin Templeton Investment, says there is a low correlation between A and H shares. “It’s probably because the A shares reflect more of the domestic consumption and the industrial activity, whereas in the H shares you have a lot more of the new economy companies. So if an investor is trying to capture the Chinese economy as whole, I don’t think investing in H shares alone would capture that. It has to be a combination of both.”
So why are foreign investors still shy of engaging directly with China?
Jack Lee, head of A-share research at Schroders, says: “My view is that QFIIs are quite conservative. Many of them are sovereigns and pension funds. But I don’t think it’s a market that is as scary as some people think. The number of good-quality stocks is quite significant.”
Corporate debt has been a concern for investors analysing Chinese companies. But Stephen Kam, senior Asian equities specialist with HSBC Global Asset Management, sees signs of improvement. “Ongoing strength in the Chinese economy has led to an improvement in corporate earnings and cash flows, which provides room for deleveraging,” he says.
Valuation is an issue and A shares, despite abundant liquidity on the mainland, continue to trade at a premium to H shares. The Hang Seng AHP index, reflecting the premium/discount on A/H, was trading at 20% (in late September) making mainland China more expensive than Hong Kong. The index contains 88-90 stocks and is cap-weighted.
Lee says it is hard to get a gauge of the true relative valuation of the markets. “If we are talking about the whole market [of 3,000 stocks], A shares are trading at a certain premium, it’s fair to say.”
But he thinks this may be misleading. “Each country has its own risk premiums, but if the markets are not fully comparable or combined, as A and H are not, it’s hard to say if the discount or premium is justified.”
Of more concern to conservative institutions are the issues of transparency, state interference and poor corporate governance, although foreign fund managers note that progress has been made in these areas. The government’s shutdown of the market mechanisms during the stockmarket crash of 2015 made MSCI’s decision to postpone index inclusion easy.
Those defending China’s action say that shutting down trading and preventing state-owned institutions from selling out for an extended period averted a much worse collapse that would have caused long-term damage to the economy. Yu referred to it as “an administrative measure” but institutional investors were certainly less inclined to buy in China after that.
The government’s use of currency controls is a key worry for any investor in China, says Chau, “because at any stage it could trigger a certain capital control that might impact investors”.
As it is, QFIIs are concerned that if there were another global or regional crisis the rules for QFII restricting capital repatriation to 20% of their portfolio in any one month will change suddenly. This was something MSCI was keen to see removed as part of its index inclusion process. China has recently been in discussion with global custodian banks about lifting the restriction, though no formal policy statement has been made.
Stock Connect is not perfect and some investors are concerned that as the channel becomes more popular daily quotas will have to be expanded.
On corporate governance, things are improving, but Lee says there are still some cultural blind spots. “A lot of Chinese corporations do not have a good understanding of what is good corporate governance at this stage. As investors, we want to find good ESG [environmental, social and governance] companies, but unfortunately a lot of Chinese companies have no idea about the E and the S. Foreign shareholder influence is limited in any case because they are not going to be a significant force, at least for the foreseeable future.”
Nonetheless, managers consider that local companies are trying to learn about global practice.
Chau observes that China’s rules and regulations are still at odds with overseas markets. Officials from CSRC and CBRC, the Chinese securities and banking regulators, are therefore working with other regulators and exchanges to make it easier for international investors to engage with China as the markets open up further.