A/B/H shares...

Investors who venture into the world of Chinese equities face an alphabet soup of seemingly random letters. There are A-shares, H-shares, S-chips and P-chips to name just a few (see Chart 1).

These letters represent various attempts to develop the equity market in a country where people traded the first shares as long ago as the 1860s. But something resembling a modern stock market, the Shenzhen Stock Exchange, didn’t start operations until December 1 1990¹ . Shenzhen beat Shanghai as the first exchange of the modern era by some three weeks².

The Hong Kong Stock Exchange, a forerunner to the city’s current bourse, began operations in 1914 but developed under British colonial rule³. Investors view Hong Kong as a separate and distinct market.

Chart 1: Alphabet soup of Chinese equities

‘A’ is for…

In 2017, the market capitalisation of listed domestic companies in China was only surpassed by that in the US, according to data compiled by the World Bank ⁶.

Chart 2: A-share universe

Number of listed companies

However, the size of this market can be misleading. A big market tends to imply a level of maturity which, in the case of A-shares, isn’t there yet.

This is a market that is still finding its feet. Since the first companies listed in the early 1990s, it has operated in isolation, largely irrelevant to investors in the rest of the world. The obstacles to foreign investor participation were, until a few years ago, so daunting that most foreigners either stayed away or only paid lip service to the idea of investing in onshore Chinese equities.

Even today, foreign investors account for only 2 per cent of share ownership, or some 5 per cent of the free float⁷ (see Chart 3). This is despite the authorities and some of the more forward-looking A-share companies saying they would like to see more foreign participation.

Chart 3: Share ownership as % of free float

Retail is not dead

On the other hand, local retail investors account for more than one-third of the free float and some 86 per cent of transactions⁸ (see Chart 4).

Retail investors in China, like their counterparts elsewhere, tend to be on the lookout for quick capital gains. They possess few investment convictions other than chasing the latest ‘hot’ tip.

This helps explain the popularity in recent years of smaller high-growth companies. This is also why most Chinese companies do not see paying dividends as a priority (A-shares are low-yielding and dividend cuts are common).

This also means that A-shares are prone to frequent bouts of high volatility driven by investor speculation and sustained by momentum trading.

Analyst coverage of the market can be patchy. This may be a good thing for investors who do their own research, but it does nothing to improve transparency and investor education.

Chart 4: Retail vs institutional trading volumes

A tale of two cities

The Shenzhen Stock Exchange was the first modern bourse in China. But Shanghai, the northern exchange chosen by policymakers in the 1990s to host the country’s restructured state-owned enterprises, overshadowed it for much of its history. Even today, investors can find the massive state-owned banks, the energy giants and the national utilities listed in Shanghai.

Shenzhen didn’t come into its own until big private sector companies, a more recent phenomenon, started listing there. This is a reflection of the growing importance of the service sector in China. The bourse hosts many of the country’s new economy companies, especially those firms that benefit most from the expansion of domestic consumption. ChiNext, China’s Nasdaq, is a second board of the Shenzhen Stock Exchange.

The southern city of Shenzhen, just across the border from Hong Kong, is known as China’s Silicon Valley (dubbed Silicon Delta). It has become a magnet for money and talent, not just from China, but from the rest of the world. The city is home to the likes of internet giant Tencent, as well as countless technology start-ups all hungry to be the next Tencent.

National service

What is unusual in China’s equity market is the interventionist role played by the so-called ‘National Team’. This is a group of government-controlled firms tasked with stabilising the market by buying shares during big sell-offs.

Deployment of the ‘National Team’ is not an official policy, but an open secret. Its existence serves as a reminder that, while policymakers have embraced some market reforms, the not-so-invisible hand of the state still plays a role in determining asset prices.

The degree of government control may come as a surprise to investors used to the lighter regulatory touch of western markets. However, it reflects the state capitalism model which has been behind China’s economic success so far.

Market development is often a tug-of-war between the need for reform and the instinct of regulators to retain control. That’s why progress on reforms can sometimes be a case of two steps forward, one step back. This is especially true during times of market stress.

A mirror on China

China needs credible capital markets that will help fund pensions for a fast ageing population. The country’s leaders know this and this knowledge has been a big catalyst for reform.

The stock markets will play a pivotal role. What everyone wants to eventually see is an efficient mechanism for investing surplus capital. This will help people save for the future, as well as allocate money to the most deserving companies.

The some 3,420 securities listed in Shanghai and Shenzhen also provide a snapshot of modern China. There’s the ‘old’ China of nationalised industries providing jobs for tens of millions of workers. But there’s also the ‘new’ China comprising agile private sector companies serving the needs of consumers.

The A-share market is a broad and deep one (see Chart 5). In many cases, this market offers the only way for foreign investors to access the sort of companies that form the backbone of China’s consumption story.

Some firms may engage in familiar activities. For example, China International Travel Service runs duty free shops set to profit from more tourism. Foshan Haitian Flavouring & Food makes condiments and is the world’s largest manufacturer of soya sauce. Anhui Conch Cement supports China’s mammoth housing and infrastructure needs.

Others are in more unusual businesses, such as traditional Chinese medicine (e.g. Beijing Tongrentang) and Chinese baijiu liquor (e.g. Kweichow Moutai). These are hard to find outside China. Market leaders at home, they also have the potential to dominate in international markets when their products head overseas in the footsteps of the Chinese diaspora⁹.

Chart 5: MSCI China A sector breakdown

Earnings potential

Earnings growth, although under pressure, looks good when assessed against comparable markets (see Chart 6). This is not across the entire A-share universe, but a smaller portfolio of 537 companies selected for the MSCI China A Onshore Index. The Onshore benchmark represents about one quarter of the market capitalisation of the entire universe¹⁰.

Having said that, consensus forecasts suggest earnings growth in 2019 for the A-share market will beat those of companies in both the MSCI World and MSCI Emerging Markets indices. Consensus forecasts for the A-share market also expect earnings to beat projections for the MSCI China Index, which tends to track Chinese equities that trade offshore¹¹.

Chinese companies do face headwinds. China has tried to curb credit growth to tackle debt levels that reached some 274 per cent of GDP by mid-2017. The country, like others, turned to debt-fuelled stimulus following the global financial crisis more than a decade ago.

Private sector companies are more susceptible to the effects of credit restrictions. There are growing signs of distress in the form of more bankruptcies and defaults. Unlike state-owned companies, these firms have few financial lifelines when bank loans dry up and regulators clamp down on unofficial sources of credit. Stock picking – a focus on cash-rich firms with strong balance sheets – can help avoid problem companies.

There is some temporary relief though. Policymakers have been easing credit restrictions because of a deteriorating external environment. Domestic consumption can also take up some of the slack from weaker external demand.

Chart 6: Earnings growth resilient

Earnings per share growth estimates (YoY)

Liquid assets

The A-share market attracts heavy trading. This shouldn’t be a surprise given the influence of retail investors in this market. These investors, given their susceptibility to rumour and speculation, tend to trade their portfolios too much. Many are oblivious to the fact that transaction costs have a negative impact on investment returns.

To show just how liquid this market is, we ranked the share turnover velocity of 63 stock exchanges in developed and emerging markets over a 12-month period. Share turnover velocity is a crude gauge of liquidity. It’s derived from dividing the number of shares traded over a period by the average number of shares outstanding during that period.

The Shenzhen Stock Exchange is the third-most liquid in the world, with the Shanghai Stock Exchange ranked fifth, based on data as of end-October 2018 compiled by the World Federation of Exchanges¹² (see Chart 7).

Chart 7: High share turnover velocity

Share turnover rate, annualised

Past isolation means low correlation

For decades the onshore market developed in isolation. Few foreign investors followed A-shares. Even today, an unsophisticated local investor base that reacts to domestic rather than external factors, drives this market.

As a result, the A-share market tends not to transmit global shocks with the same intensity as markets elsewhere. The onshore market has therefore been an effective way for foreign investors to diversify a portfolio.

A review of the 15-year relationship between the MSCI China A index and five other indicies shows the lowest correlation with MSCI World Index¹³ (see Chart 8). The highest correlation, perhaps unsurprisingly, is with MSCI China. The other indices were MSCI Emerging Markets, MSCI Emerging Markets Asia and MSCI Asia ex-Japan.

There are several reasons for this. Foreign investors play such a small role that the A-share market isn’t so susceptible to capital flight. Growing numbers of Chinese companies who depend on domestic demand aren’t as affected by global economic and interest rate cycles. Government-linked firms support the A-share market during periods of weakness.

What’s more, the retail nature of the local market means trading often bears no relation to what’s happening in businesses and the economy.

Meanwhile, the renminbi is one of the most heavily-managed currencies in the world. This helps dampen volatility for foreign investors and we have not seen the sort of currency capitulation that devalued the Argentine peso and Turkish lira in 2018.

Chart 8: Lower correlation with global markets

15 year correlation, based on monthly data, USD unhedged indices

Rolling 3 year correlation for MSCI A-shares vs key indices (USD unhedged)

Index considerations

MSCI added more than 220 China A-shares to its ACWI and Emerging Markets indices in June and September 2018. This followed years of feasibility studies and market consultations.

Before the year was over, the index provider announced its intention to raise the weighting of A-shares to 20 per cent from the initial 5 per cent. If approved, this will happen in two stages in May and August 2019. MSCI also proposed to make securities listed on ChiNext eligible for inclusion, with mid-cap securities qualifying in May 2020¹⁴.

Furthermore, another index provider, FTSE Russell, is planning a phased index inclusion starting in June 2019, with the A-share weighting likely to reach some 5.5 per cent¹⁵.

Adding A-shares into these widely-followed indices could siphon at least $11 billion of passive money into China¹⁶. However, the implications are even more far-reaching.

Index inclusion serves as an endorsement that will encourage many international investors to consider this market for the first time. This includes institutional investors who may add stability to the Chinese market.

More progressive A-share companies will seek to attract capital from foreign institutional investors because this money tends to be ‘stickier’, or less susceptible to short-term sentiment. A foreign investor base could help boost a company’s profile offshore and support any overseas ambitions it may have. Foreign investors could even enhance a company’s reputation at home.

To keep their new investors happy, firms will be more receptive to suggestions on how to improve corporate governance. For example, more could adopt stock-related compensation schemes that align the interests of management with those of shareholders.

Road to Stock Connect

As recently as 2014, foreign private sector investors who wanted to access the A-share market had few options. They had to get a Qualified Foreign Institutional Investor (QFII) or a Renminbi Qualified Foreign Institutional Investor (RQFII) licence.

This was a painful process. Application and approval took a long time. Investors were subject to investment quotas. There were restrictions on the repatriation of profits. Public sector investors – foreign central banks, supranationals and sovereign wealth funds – were governed by separate rules.

Then came another option – the Stock Connect trading platform. This allows investors to trade shares in Shanghai and Shenzhen via the Hong Kong bourse (and vice versa). The Shanghai-Hong Kong Stock Connect began operations in 2014, while the Shenzhen-Hong Kong Stock Connect launched two years later.

Getting connected

The launch of Stock Connect means it has never been easier for foreign investors to access China’s onshore equity market. Foreigners covering the Chinese market had been waiting for something like this for years.

This trading platform removed the red tape that was one of the most daunting obstacles in the way of investing onshore. Stock Connect cuts the amount of time and effort needed to buy and sell A-shares for investors based outside the mainland.

Today, anyone with a stock trading account at a brokerage in Hong Kong can trade shares from a selection of some 1,500 onshore securities. Accounts are denominated in the fully convertible Hong Kong dollar (trading and settlement are in renminbi with foreign exchange conversion handled offshore). Settlement is T+1 (the day following a trade).

Residual restrictions

Stock Connect doesn’t give foreigners access to all the approximately 3,420 securities in the A-share universe. Trading is subject to daily quotas (although regulators have raised them). Different public holidays in Hong Kong and the mainland can disrupt trading and settlement.

Day trading – the buying and selling of a security within a daily trading session – is prohibited. Margin trading – trading with money borrowed from a broker – is only permitted for certain Shanghai-listed securities.

There are restrictions on covered short-selling – selling borrowed shares – of selected Shanghai-listed securities. There are also caps on foreign ownership of individual stocks. That said, ownership restrictions have been relaxed for selected parts of the financial industry, such as asset management companies.

Futures and options

Equity derivatives in China can be best described as ‘under development’. Regulations can change at any time but, at the time of writing, this market excludes foreign investors unless they operate a wholly foreign-owned enterprise (WFOE). This is an investment vehicle that allows foreigners to run a limited liability company without a local partner¹⁷ .

That said, lack of access hasn’t been a big issue since most foreign investors run long-only strategies. Some hedge funds may be unhappy but they can circumvent restrictions by entering into swap contracts with offshore banks.

For investors who do have access, CSI300 (large and mid-cap), SSE50 (large cap) and CSI500 (small cap) index futures can be traded on the China Financial Futures Exchange. Respective monthly turnover is around RMB700 billion (US$104 billion), RMB300 billion (US$ 45 billion) and RMB400 billion (US$ 59 billion).

There are different trading restrictions depending whether you have a ‘hedging’ or ‘trading’ account. For example, there is a 50-contract daily new contract opening limit for trading accounts, whereas hedging accounts can operate with no such limit.

The most popular equity option contracts are SSE50 exchange traded fund options that are traded in Shanghai. The maximum long position limit is 5000 contracts (equivalent to an underlying exposure of RMB125 million or US$18.5 million). The maximum total position limit (long and short) is 10,000 contracts.

Heading home

Chinese companies once viewed an overseas listing, especially in the US, as a sign that a firm had finally arrived in the world. Overseas listings promise better standards of accounting and disclosure which can also be more attractive for foreign investors.

High-profile companies such as Alibaba and Tencent still go offshore. The former has a primary listing in New York, the latter in Hong Kong.

But the experience of overseas-listed Chinese companies can be disappointing. Many struggle to generate and sustain investor interest. Despite higher standards overseas, there have been cases of corporate fraud which have tarnished the reputation of legitimate businesses.

Chinese companies with securities listed in the US are also subject to a broad range of US rules. This can be a problem when, for example, a state-owned enterprise wants to do business with a country that’s been placed under US sanctions.

Policymakers in China have spent the past few years trying to persuade overseas-listed Chinese companies to return home. For all these reasons, Chinese firms that listed overseas a decade ago or more have been heading in the opposite direction.

Every successful repatriation expands the pool of potential investments. For example, Qihoo 360 Technology, an internet company, delisted from New York in 2016 and re-emerged in Shanghai two years later via a back door listing. Wuxi AppTec, a contract medical researcher, left New York in 2016 and relisted on the Shanghai bourse in 2018¹⁸.

Policymakers have also finalised the regulatory framework for the launch of Chinese Depository Receipts (CDRs). CDRs are a local version of the American Depository Receipt which will give Chinese investors access to overseas-listed Chinese companies.

This development will have less significance for foreign investors because they have unrestricted access to these companies offshore. It is, nevertheless, another example of how reforms are slowly changing local markets.

Investors face the usual risks of investing in emerging markets and their currencies. In addition, investors in China’s A-share markets need to understand these unique risks.

Untested regulations

The rules that govern investing via QFIIs and RQFIIs are relatively new, novel and subject to revisions. The application and interpretation of those rules are untested and there is no certainty over how they will be applied.

This is even more the case with the regulations that govern the Stock Connect platform. A-shares traded via Stock Connect are subject to mainland laws and regulations. While concepts of ‘beneficial ownership’ and ‘nominee holdings’ are referred to under Chinese regulations, they are untested in the mainland courts. There is no guarantee these courts will recognise them in the event of a liquidation of a company’s assets. Mainland shares bought via Stock Connect are held by a sub-custodian in accounts with the Hong Kong Securities Clearing Company, which acts as the ‘nominee holder’.

While investors’ ownership may be ultimately recognised, there could be difficulties or delays when enforcing ownership rights.

Stock suspensions

Listed companies have the option to suspend trading of their own shares, an option that’s often exercised on the flimsiest of pretexts. These shares can remain suspended for months at a time.

During the height of the big market selloff of mid-2015, some 1,200 out of 2,808 listed companies applied for voluntary suspension. This was an unprecedented move amid efforts to avert a market meltdown. On that occasion, stock suspensions helped stop a share rout from turning into a systemic risk.

However, suspensions happen far too often. In such cases they prevent the normal functioning of the market and cause illiquidity.

That’s why, starting in November 2018, the China Securities Regulatory Commission announced a series of ‘guiding’ principles. These principles require companies to improve communication and transparency, and avoid long-term trading suspensions. Crucially, the new guidelines limit the circumstances under which a company can apply for suspension.

The issue of stock suspensions has been a bugbear for foreigners. Corporate governance standards in China are generally poor. This topic is addressed in more detail in Finding the ‘G’ in ESG. However, as policymakers seek to attract more foreign investor participation, they are making efforts to address concerns.

Slowing growth

The economy grew 6.5 per cent in 2018 and our economists are forecasting growth to decelerate to 6.1 per cent in 2019, and 5.8 per cent in 2020²³.

Even before the US-China trade war started keeping investors awake at night, China was already deleveraging to wean the economy off a decade of debt-fuelled stimulus. Stimulus had helped the country emerge unscathed from the global financial crisis.

But stimulus policies had funnelled money into unproductive investments. Recent moves to curb access to credit caused more damage for the private sector. These are companies that form the backbone of the consumer-driven, new-look economy that China wants to create. Defaults are rising and business sentiment is weakening.

There may be a temporary ceasefire with the US on trade. However, we see few signs that a sustainable circuit breaker on this, or broader geo-political tensions, are on the cards.

Chinese policymakers are trying to mitigate some of the effects of this deterioration in the business environment by resorting to stimulus again, albeit on a more modest scale. While this will prop up growth in the short term, it cannot (and will not) be a long-term solution.

The years when China’s economy grew each year at double-digits are gone. But even with annual growth of just over 6 per cent a year, China will account for some one-third of global GDP growth.

Taxation

Current rules offer temporary tax relief for foreign investors who have been investing in locally-listed shares since October/November 2014.

‘Caishui 2014 No. 79’ states that QFIIs and RQFIIs without an ‘establishment or place’ in China are temporarily exempt from withholding income tax on gains derived from equity investments after November 14 2014.

Meanwhile, ‘Caishui 2014 No. 81’ (October 31 2014) and ‘Caishui 2016 No. 127’ (December 5 2016) state that corporate income tax, individual income tax and business tax are temporarily waived on gains derived by Hong Kong and overseas investors on the trading of A-shares via Stock Connect.

That said, tax on dividends and bonus shares are still levied unless the investor is a tax resident of a jurisdiction that has signed a tax treaty with China which confers preferential treatment.

Tax relief, where it exists, is only temporary and the risk is that these rules may change at any time and taxes levied retrospectively.

Capital controls

Capital controls pose a risk, albeit a small one. The renminbi is a managed currency and there are restrictions on the cross-border movement of money.

We believe any sustained attempt to prevent foreign investors from repatriating profits will damage China’s goal of opening up its capital market to overseas investment.

When Thailand imposed capital controls in December 2006, the move scared off foreign investors who were slow to return even after restrictions ended. Policymakers around the region would have learned that lesson well.

The Stock Connect scheme has also made capital repatriation much easier.

Currency risks

The renminbi is one of the most heavily managed currencies in the world. Currency management provides stability which helps dampen volatility for foreign investors.

But over the long term, many economists believe it is impossible to combine: a fixed and stable exchange rate; an independent monetary policy; and free international capital flows.

Most countries make do with two of the three. Attempts to achieve all three – as China is doing – have been disastrous. If China is forced to give up one component of the so-called ‘impossible trinity’, control of the currency could be at the top of the list.

That said, the likelihood of policymakers relinquishing control of the renminbi in the short term is still remote.

Investors outside China have enjoyed easier access to A-shares for some years now. But with FTSE Russell planning to add this asset class to a regional benchmark in 2019, and MSCI considering letting A-shares play a more important role in its own indices, there is little excuse for investors to dismiss this market as either parochial or irrelevant.

This is a market that is maturing. Both policymakers and market players are keen to introduce more professionalism to create a capital market more befitting China’s economic status. For investors with a greater risk appetite, a short-term trading strategy has yielded handsome rewards in the past. For those with a longer-term view, there are hidden gems to be unearthed.

China is the world’s second-largest economy, one that is set to overtake that of the US within a generation. It has created wealth and enriched its people in an unprecedented manner. In doing so, the Chinese have become one of the most powerful forces shaping consumption behaviour in the world today. A-shares offer unrivalled access to these historic changes.

That said, the development of the onshore equity market has lagged economic development. Growth hasn’t translated smoothly into broad-based and sustained share price gains. Standards of corporate governance, while improving, compare unfavourably with other markets. Investors who deploy passive strategies will likely be disappointed over the long run.

China also faces new uncertainties. It is trying to balance growth and sustainability. It must conduct business in a world that is more hostile to its goals. Changes in internal politics could deliver stability or just as easily stoke resistance.

Investing in A-shares may be riskier than investing in more established equity markets. But it is no more risky that investing in other emerging markets. They deserve, at the very least, careful consideration.

Today, the bigger risk for investors is ignorance. Should you invest in the market because the index weight is increasing? No! But you should spend the time necessary to understand the potential of the market before the index-following crowd arrives.