China may be the spectacular growth story of our time, yet for all its might the country has an insular and undeveloped domestic equity market. Beijing invests trillions of state funds in international stocks, bonds, currencies, and hard assets. And Hong Kong, with its long ties to London, is a bona fide financial center. Yet mainland Chinese who want to be in equities are restricted to investing in domestic, yuan-denominated A shares on the Shenzhen and Shanghai stock exchanges, home to indexes that are prone to speculative mania.
“Mainlanders have only domestic-listed stocks, bank deposits, or real estate to pack their money in,” says Jun Zhu, an analyst who follows China for Minneapolis-based Leuthold Weeden Capital Management. “And cash is plenty. So you get inflated equity valuations, elevated housing prices—prices of everything, pretty much.” In 2007, when local markets were up sixfold in less than two years, the Chinese press was full of stories about retirees handing over their life savings to brokerage houses and students skipping meals to raise cash for hot initial public offerings. Shares whose prices closed on the lucky number eight were all the rage.
Now, mainlanders will finally get the chance to invest their restive yuan abroad. In August, Vice-Premier Li Keqiang announced that exchange-traded funds based on Hong Kong equities would be available on China’s mainland exchanges in Shenzhen and Shanghai. The decision is a significant step forward in Beijing’s long-term drive to build up Chinese equity markets, to encourage wider use of the yuan, and to bolster the country’s credentials as a global investing hub. “The new investment products should increase cross-border portfolio fund flows over time,” says Jing Ulrich, Hong Kong-based chairman of global markets for China at JPMorgan Chase (JPM). She says Beijing is getting ambitious about the internationalization of the yuan and expanding capital flows between the mainland and Hong Kong.
The most immediate beneficiary of the move will be Hong Kong’s bourse. Leuthold’s Zhu calculates that over the past 10 years the share prices of Chinese companies listed in Hong Kong and the U.S. have traded on average at a 56 percent discount (based on price-to-earnings multiples) compared with their A-share counterparts on the two mainland exchanges. That mainland investors are willing to pay a premium is a telltale sign of pent-up demand among domestic Chinese investors for international stocks listed in Hong Kong, she says. “Hong Kong is just a testing ground and a very important one,” says Zhu. “Once the door is cracked opened between the mainland and Hong Kong, mainland investors will gain access to the whole world—including London and the U.S.—eventually.”
The dilemma Beijing faces is how to balance the desire of mainlanders for more investment options with the country’s practice of micromanaging its currency vis-à-vis the dollar and other foreign currencies to promote exports. The yuan has strengthened 3.4 percent against the dollar this year, the best performance among 25 emerging-market currencies, according to data compiled by Bloomberg.
In recent years, China has taken steps to increase capital flows in and out of the country. Over the past decade foreign institutional investors have gained greater access to so-called B shares, Chinese stocks that trade in foreign currencies on the Shanghai and Shenzhen exchanges. In early September, British Chancellor of the Exchequer George Osborne and visiting Chinese Vice-Premier Wang Qishan announced plans for both countries to collaborate on the development of yuan-denominated investment products and lending in London, the world’s biggest foreign currency trading center. Singapore also has aspirations to become a major offshore center for Chinese currency transactions. Last year sales of yuan-denominated debt, dubbed Dim Sum bonds, in Hong Kong surged to 35.7 billion yuan ($5.4 billion), from 16 billion yuan in 2009. (This year, though, the Dim Sum market has suffered as Europe’s debt crisis has made risky emerging market assets look less appetizing.)
China is still a long way from allowing unfettered two-way capital flows. There are no plans to dismantle Beijing’s relatively tight capital-control regime, which would mean a loss of power over the nation’s wealth that some inside President Hu Jintao’s government might be reluctant to give up. “Beijing has undergone an internal tug of war since 1979 on how much to loosen control over not just the Chinese economy, but also on their entire society,” says Jim Trippon, editor of the China Stock Digest.
Chinese authorities will continue to explore ways to promote the yuan as a recognized alternative to the dollar in global trade and finance and China as a tier-1 destination for international listings—and they are building upon Hong Kong’s established capital markets infrastructure to that end. “Unleashing the yuan as a respected and liquid global currency is the ultimate goal,” says Trippon. In other words, Beijing wants to liberalize the market, but with minimum trade-offs. Despite China’s dueling desires, Goldman Sachs (GS) believes China’s stock market value will exceed that of the U.S.—now $14 trillion—in about 20 years. How it gets there remains in the hands of a few powerful men in Beijing.