Tuesday, 23 October 2007

Arbitrage and the Shanghai and Shenzhen bourses

The Chinese stock market is rarely out of the news as it continues its relentless climb into unknown territory. The higher it gets the further it will eventually fall. Japan in the later 1980s or the Nasdaq in late 2000 early 2001 appears to be the closest.

So where does the Hong Kong bourse fit in? It has not experienced anything like the same bubble creation (altough there are signs of one forming). Both bourses are in China so why not merge them?

The FT tackle this issue and conclude that it is mighty complicated. Of course it is all to do with capital flow restrictions and the lack of other investment opportunities for the Chinese to invest in.

It is ludicrous that company shares on the two bourses can have valuation gaps of up to 50%. This throws economics out of the window but it is all artifical and only serves to illustrate how out of kilter Chinese A stock prices have become.

What is interesting is that in China if a share price is going up it appears in RED. In the West red means a share price has fallen. Of course with a little thought one should not be in the least suprised.

Integration of Chinese bourses complicated

When it comes to knitting together Hong Kong and China’s financial systems – the promise of which briefly propelled the territory’s benchmark Hang Seng Index past 30,000 points last week – this red light-green light discrepancy is the least of the two markets’ challenges.

Where ardent integrationists talk of possible “arbitrage mechanisms” that could help reduce a stubborn cross-border valuation gap, sceptics smell a red herring and argue that China’s strict capital controls make true cross-border arbitrage as likely as alchemy. Forty-nine Chinese companies have listed both mainland-traded A-shares and Hong Kong H - shares. PetroChina’s upcoming $9bn A-share offering in Shanghai will add another name to the ranks of China’s dual-listed companies. Ever since China’s stock market began its record run in the summer of 2005, sending Shanghai’s benchmark index up sixfold, dual-listed companies’ A-shares have consistently out-paced their H-shares.

The recent rally in Hong Kong has narrowed the gap. Jing Ulrich, chairman of JPMorgan’s China equities business, says that the average A-share premium has shrunk to 55 per cent on a weighted-average basis, and predicts it will narrow to 35 per cent by the end of 2008. Even so, share price discrepancies can still be substantial. Sinopec Shanghai Petrochemical and Sinopec Yizheng Chemical Fibre’s A-shares are trading at more than three times the value of their H-shares.

Last week, rumours that Chinese authorities were contemplating a share swap mechanism boosted Hong Kong shares and depressed Chinese ones. This reflected investor expectations that if real arbitrage were possible, H-shares would rise and A-shares fall until they reached equilibrium. How such arbitrage could be achieved so long as China enforces strict capital controls – making it impossible for mainland investors to buy shares freely in Hong Kong and vice versa – remains in dispute.

Joseph Yam, chief executive of the Hong Kong Monetary Authority, enlivened the debate in February, when he wrote about the creation of a channel between the two markets, possibly based on “certificates of ownership of shares listed on the Shanghai, Shenzhen and Hong Kong stock exchanges . . . traded in both markets with an arbitrage mechanism to equalise prices.

“I am sure there are many fine financial architects capable of designing a channel to link the two financial systems,” he said. “Admittedly, there are many policy issues to deal with. But now is the time to do it.”

In the ensuing nine months,Hong Kong government officials have echoed Mr Yam’s refrain with urgency, pointing to the A- share/H-share valuation gap as if it were a freak of nature that must be set right.

Their calls culminated with the government’s surprise purchase of a controlling 5.8 per cent stake in Hong Kong Exchanges and Clearing last month, in a move that the territory’s financial secretary said “underlines the government’s support for HKEx and enables the government, over the longer term, to contribute as a shareholder to the promotion of HKEx’s strategic development”.

The Hong Kong government controls the stock exchange’s board through appointment powers and bars any one party from taking more than a 5 per cent stake in HKEx without approval. For its part, the Hong Kong stock exchange has been notably cooler about the prospects for arbitrage opportunities, given China’s closed capital account. “The price gaps between the A- and H-shares reflect the non-fungibility between the Shanghai and Hong Kong markets,” the exchange said yesterday. “HKEx will consider any feasible plans it receives for an arbitrage mechanism.”


“A-share valuations are likely to moderate over time as earnings rise and new share supply is increased, while the QDII and through-train programmes will support a continued re-rating in H-share prices,” Ms Ulrich says. “As outbound capital channels continue to widen, the A-share premium is likely to narrow substantially, even before China’s capital account is fully open.”


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