After a mainland equity collapse in 2007, investors the world over largely wrote off Shanghai’s stock exchange as the lesser cousin of regional heavyweight Hong Kong. But tides have turned since the middle of last year, when the Shanghai Composite Index started rocketing upwards from around 2,500 points to above 3,600 points in recent days, a peak in about seven years.
The recent rally may have set foreign investors salivating once again at the prospect of snapping up Shanghai stocks. But economists and financial market experts warn that the speed of the surge and its contrast with wider macroeconomic conditions raise questions of the market’s credibility; they say there are still scores of barriers before the exchange becomes a market that investors can truly trust.
The first issue is whether the stock market’s bullish run tallies with firm’s earnings and China’s economic reality. Unlike previous up-and-downs of the market, which largely mirrored the broader economic prospect of China, a key driver of the current uptick is the protracted slump in real estate throughout much of China. For now, the downturn appears to have effectively ended the property sector’s role as a dependable earner for institutional investors and more importantly, profitable storehouse for value among retail investors—at least outside of top-tier cities such as Beijing and Shanghai. That has left only one sector where profit is possible: equities.
But the influx of inexperienced retail investors, whose knowledge of trading began with “buy low” and ended with “sell high”, is a worrying factor for the stability of the market. A recent Bloomberg report said that as much as 80% of equity trading in China is done by individual investors, who likely lack necessary analytical skills to make rational investments.
Another crucial factor that prohibits Shanghai’s exchange from becoming a friendly market for global investors is the tight grip the Chinese government has on cross-border capital flows. Foreign investments into the Shanghai market are still subject to quota controls as well as governmental approvals.
“Shanghai can’t really become an international finance center until they’ve opened up the capital account and made the renminbi fairly convertible on that capital account,” says Julian Evans-Pritchard, China Economist at Capital Economics. “[Investors] need to be able to freely shift funds across the border and convert them into different currencies.”
The positive side is that China’s regulators are slowly opening up China’s capital account. The launch of the Hong Kong-Shanghai Stock Connect, which allows traders at each exchange to buy and sell certain stocks in the other, is deemed as a strong driver of the market’s upside momentum.
However, it soon became clear that the Stock Connect was not as user-friendly as many international investors would have liked, because “there’s just more counterparty risk involved than people had expected,” says Haohao Zhou, China economist for ANZ.
“If you want to sell your stock on a particular day, you have to deliver all your stocks to the brokerage company before the trading kicks off… and most of the typical institutional investors in Hong Kong just do not feel comfortable enough with that,” Zhou adds.
As a result of the limitations of the program, much of the international exposure to mainland shares now seems to be coming from privately traded derivatives in Hong Kong. A recent Reuters report found that most Stock Connect activity was occurring off-exchange as funds bought “synthetic” equity—financial tools that grant exposure to a stock’s gains and losses—to increase their China exposure.
Zennon Kapron, founder and Managing Director of the China-based financial consulting firm Kapronasia, suggests that this focus on synthetic equity was likely to dissipate in the longer term as the market linkup’s scope broadened and regulations were eased. He adds that China’s lack of domestic derivatives was another factor that detracted from the Shanghai Stock Exchange’s international appeal, even as its impact on the global financial system increased.
“There are certainly a subset of these investors that have not come into the [Shanghai] market because of the inability to hedge,” Kapron says. “As we have seen in the latter half of 2014 and beginning of 2015, the Shanghai Stock Exchange can be quite volatile.”
“I think the bigger issue is trust and faith in the legal system,” Evans-Pritchard says. “It’s harder to build that trust, and I think there’s still quite a significant amount of wariness of how well investors’ rights will be protected in the mainland. Investors want exposure to China but they don’t necessarily want to deal with the legal uncertainties that would be involved in investing from within China itself.”
This all may change in the long run as reforms are gradually rolled out. But so long as Shanghai’s market lacks the global liquidity and institutional trust that underpins other major stock exchanges’ financial fundamentals, its international significance will remain limited.
