Enjoy it while it lasts.

Photographer: Anthony Kwan/Getty Images

Hong Kong Embraces China's Bubble

a | A

Bill Gross of Janus Capital says his next great short trade may be Chinese stocks. With the Shenzhen and Shanghai markets up another 9 percent this week, it's not hard to understand why. But the investment guru might want to consider betting against Hong Kong, too, given that city's continued courting of high-volume traders from mainland China.

Hong Kong's trading tax has generally dissuaded the West's high-frequency trading firms from doing business there. But the city's stock exchange is now explicitly enticing China's hundreds of millions of eager daytraders -- whose frenetic high-volume investing can be just as volatile as that of high-frequency trading technology -- to take advantage of the mainland's new financial link with the city. Years from now, Hong Kong will almost certainly regret extending the invitation.

There are now more stock-trading accounts in mainland China than there are people in Brazil -- more than 200 million, and counting. Surging stocks have become the Communist Party's catch all strategy amid the country's economic downturn, a way to help companies cut debt, boost local-government revenues and accelerate the government's privatization plans.

But it has also instilled a sense of irrational exuberance among Chinese traders who are ignoring China's worsening economic outlook. On Friday, the Shanghai Composite Index climbed above 5,000 for the first time in seven years; Gross has been especially transfixed by the 190 percent jump in Shenzhen stocks in the past 12 months, a rally he calls "almost hyperbolic."

A case in point is China National Nuclear Power, which attracted $273 billion of bids this week for a $2 billion share sale. Meanwhile, shares of the 144 companies that went public this year are up an average 539 percent so far (44 percent increase on the first day of trading). There seems to be little immediate incentive for investors to slow their trading.

Hong Kong, which had previously been separated from China financial free-for-all, is now keen to join the party. So keen, in fact, that it's forgetting the basics that made Hong Kong a model for free-market enthusiasts. The city's low taxes, unfettered capital flows and rule of law routinely earn recognition as the world's freest economy.

In its haste to win more mainland money, though, Hong Kong is now risking its reputation for sound and dispassionate management. Introducing the mainland's high-frequency-trading dynamic could open it to all kinds of dodgy dealings (as Nick Leeson, the rogue trader who brought down a major British bank 20 year ago, warned last month).

In the short term, Hong Kong markets can expect an increase in volatility as hundreds of millions of mainland traders start heading Hong Kong's way. The value of the 10 Hong Kong shares most often traded by mainland investors more than tripled in April, increasing at almost twice the rate as the benchmark Hang Seng Index. It's only a matter of time until that surge, and others like it, reverses itself.

Hong Kong should focus on improving its financial infrastructure. At the very least, it should create a so-called circuit breaker mechanism, which would allow it to temporarily halt trading activity if prices plunge too suddenly. It also should consider halting the use of its stock market link with mainland China until the city's regulators are ready for the oncoming waves of volatility.

It's understandable that Hong Kong sees mainlanders as a ready source of market liquidity. But they shouldn't be surprised if Gross and his peers start seeing Hong Kong's stock market as the next great short trade.

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

To contact the author on this story:
Willie Pesek at wpesek@bloomberg.net

To contact the editor on this story:
Cameron Abadi at cabadi2@bloomberg.net