Stock Connect with London could be adversely affected by ripple effects in market
Over the past few years, Stock Connect (Shanghai-Hong Kong in 2014 and Shenzhen-Hong Kong in 2015) and Bond Connect (Shanghai-Hong Kong in 2017 ) have both been given big stamps of approval as global index compilers add Chinese assets into their major international benchmark indices for the first time.
MSCI completed its A-share inclusion plan in August; FTSE Russell planned for inclusion in September. Meanwhile, Bloomberg will add Chinese bonds into its Barclays Global Composite Index in April.
These moves will drive massive international money flows into the Chinese mainland market, fueling the country’s plans to internationalize its capital markets and bring value to investors and market players both domestically and globally. We describe these connects as bridges that bring China closer to the international community.
Now, a new bridge, called Shanghai-London Stock Connect, has launched. As a connectivity mechanism between the Shanghai Stock Exchange and the London Stock Exchange, Shanghai-London Stock Connect refers to the arrangement that the eligible companies listed in the two countries issue the depositary receipts and list and trade them on the other side’s market according to the laws and regulations for the other side’s market. At the same time, through the cross-border conversion mechanism between depositary receipts and underlying securities, the connectivity of the two markets will be realized. There are two business directions, eastbound and westbound. The eastbound business means that the LSE-listed companies list the Chinese deposit receipts on the SSE. In the westbound business, the A-share companies on the SSE list the global deposit receipts on the LSE.
How is the new bridge different from the existing ones? In short, the Shanghai (Shenzhen)-Hong Kong arrangement is a two-way market in which investors cross the border but products are still in each other’s markets, while the Shanghai-London Stock Connect is to convert the shares of the other markets into a debit record, or DR, to be listed and traded in the local market. The products cross borders, but the investors are still in the local market.
Essentially, these connects remain a financial infrastructure, which has three major positionings: the core support of resource allocation, the important channel of monetary policy transmission and the platform of cross-institution, cross-market, cross-region and cross-border financial activities.
Since then, the benefits of the connect are clear, Shanghai-London Stock Connect has great significance in the following aspects. First of all, it is conducive to expanding the two-way opening up of China’s capital market, improving the function and internationalization of the domestic market, driving the domestic securities institutions to conduct the cross-border securities business and enhancing the international competitiveness of the securities industry.
Second, the initiative provides an opportunity for the issuers and investors in both countries to access the market on the other side for investment and financing, enables domestic residents to invest in overseas products on the local market, supports the A-share listed companies to raise funds from overseas markets, and bolsters the entity enterprises’ efforts in cross-border financing and mergers and acquisitions.
Third, it will contribute to building Shanghai into an international financial center – just as the existing connects have strengthened Hong Kong’s position. Shanghai will not only reap fresh fund liquidity, but also get the trust of regulators and numerous domestic and overseas investors.
Furthermore, it will also help the internationalization of the yuan in line with China’s strategy. With the rising volatility of the yuan exchange rate, market players need comprehensive solutions. China’s central bank is to promote financial infrastructure more actively, and investment funds or individual investors need a more useful cross-border capital flow channel. Shanghai-London Stock Connect will contribute to the global supply of yuan, and can improve the brand image of the currency.
Why London? Apparently, the prolonged trade conflict triggered by the United States has brought China even closer to Europe. Both sides have a sound political and economic foundation – the EU is China’s largest trading partner, largest source of imports and second largest export market, while China is the EU’s second largest trading partner, largest source of imports and second largest export market. China and the EU established a comprehensive strategic partnership in 2003 and launched negotiations on an investment agreement in 2014.
Meanwhile, the EU, led by the UK, has responded positively to the Chinese government’s strategy of internationalizing the yuan in the past decade. London has become the most important offshore yuan market outside Asia, driven by the governments of China and the UK. According to SWIFT’s offshore yuan business ranking, the UK jumped to second place in April 2016 after overtaking Singapore in market share. Meanwhile, the turnover of RMB-denominated foreign exchange products in the UK’s foreign exchange market has always been the top one of the global offshore yuan market. The Shanghai-London Stock Connect could establish London as the leading RMB offshore market besides China.
But the smooth start of Shanghai-London Stock Connect still faces many challenges. At home, GDP growth is slowing and the government faces the daunting task of deleveraging and reform of State-owned enterprises. The transition from externally driven growth to domestically driven growth is a complex one that, if mishandled, could lead to growth disruptions and increased financial instability.
In the international market, China has to face more protectionism and provocation from the US administration, which may greatly increase the uncertainty of trade and financial flows and make the opening of China’s capital markets face unpredictable consequences.
And it is clear that the biggest risk is that British stock markets will be affected by the Brexit process. The FTSE Index has been weak compared with the Dow Jones Index of the United States for almost two years.
Britain postponed a Dec 11 vote on a deal to leave the European Union, raising the prospect of a “no-deal Brexit”. Even if successful, the British stock market and even the European stock market are hit hard if there is a significant blow to the British real economy. And it is likely that hedge funds from Europe would flow to the United States again, which is very unfavorable to the financing activities of Chinese companies through Shanghai-London Stock Connect.
The author is a research fellow at the CEIBS Lujiazui Institute of International Finance. The views do not necessarily reflect those of China Daily.
(China Daily European Weekly 12/14/2018 page13)