A Window On The Chinese Markets

December 12, 2007


In 1997, the United Kingdom transferred sovereignty of Hong Kong, which had been one of its colonies since 1842, back to the People’s Republic of China, thereby setting the stage for the development of an entirely unique and somewhat paradoxical relationship. The handover paired the world’s freest economy with one that numbered among the world’s most insulated and restricted. It also created an intriguing scenario in which an emerging market, for all intents and purposes, acquired a fully developed market.

Hong Kong will operate with a large degree of independence from China as one of the country’s special administrative regions until its reintegration with the rest of China in 2047. As such, Hong Kong maintains its own legal and monetary systems, among its many other freedoms; the arrangement has been referred to as the “one country (China), two systems” policy. From a global investment perspective, however, the most important aspect of Hong Kong’s quasi-independent status is likely its largely independent stock market. And given the way the mainland’s stock markets are set up, Hong Kong’s market is no minor detail from China’s point of view either.

Today, China is experiencing growth unprecedented at the global level. A huge population, rapid industrialization and cheap resources have all combined to send the country’s economy hurtling forward and bring it to a critical stage in its development. GDP growth has exceeded 10 percent for successive years, and everyone from leading investment banks to sophisticated pension plans are looking for ways to invest in that growth.

China, however, is a difficult and complicated market in which to invest, and gauging its movements can be a highly nuanced task. For one thing, domestic and foreign investors are essentially trading in two parallel universes. In fact, most are quite literally trading in separate markets, with domestic investors restricted to the mainland stock markets and international investors limited to the Hong Kong exchange.

At the heart of the matter lies China’s unique share structure, which has several types of shares that are available to different kinds of investors.

A shares are traded in renminbi, China’s local currency, and are available almost exclusively to domestic investors; foreign investors, with few exceptions, cannot access these markets.

B shares are traded on the domestic Shanghai and Shenzhen exchanges, but are traded in U.S. and Hong Kong dollars, respectively, and were originally designed for foreign investors. Still, these are not the preferred means of gaining exposure to China for most investors; there are only 110 B share stocks, and in the early days of trading, those stocks were small, thinly traded and subject to manipulation.

H shares are traded in Hong Kong dollars, and are the shares most foreign investors use to gain exposure to China’s economy. H shares are shares in mainland China companies that trade on the Hong Kong stock exchange (HKSE). Among the advantages attributed to the H shares are that they trade on a developed market’s exchange, where they must meet stricter listing requirements than China’s B shares.

Sometimes companies are dual-listed on both the Hong Kong exchange and a mainland China exchange, so that they have H and A shares. Although stocks in China also list on the New York and London stock exchanges, Hong Kong remains the main gateway to China’s markets for global investors.

Opening China’s Markets
A number of steps have been taken over the years by China toward integrating Hong Kong’s economy with its own and toward liberalizing its own economy. For example, in 2003, it introduced the Closer Economic Partnership Arrangement, which all but eliminated tariffs between Hong Kong and China, and moved toward liberalizing and promoting trade between them. Prior to that, in 2002, it introduced the Qualified Foreign Institutional Investor (QFII) program, which allows foreign institutional investors licensed by the government to trade in the A-shares market through special accounts. Although the QFII program is very limited in scope, it is a step toward more open markets and does provide some access to the actual mainland China stock market to foreign investors.

The QFII program was followed up with the complementary Qualified Domestic Institutional Investor (QDII) program in 2006, which allows domestic investors to gain exposure to certain foreign investments through accounts with certain commercial banks in China.

In August 2007, the Chinese government announced plans for a pilot program that would allow investors in the Tianjian Binhai New Area—one of China’s designated special economic zones, where the government sometimes tests experimental reforms—to invest in H shares through special accounts. The announcement helped push Hong Kong’s Hang Seng Index up nearly 50 percent in the following months, as investors anticipated an influx of new money from the mainland. However, the Chinese government began backing away from the plan early on. By November, China’s Premier Wen Jiabao announced that the program would be delayed until certain conditions could be met. The reasons behind the delay appear to have been: the success of the QDII program; concerns about how an overheated Hong Kong stock market would react to the influx of mainland investors; and concerns about the relative inexperience of mainland investors with regard to global stock markets.

Regardless of the reasoning, however, the news was a shock to international and Hong Kong investors, and helped kick off a 5 percent drop in the Hang Seng Index, its worst one-day decline since the days following the September 11 attacks.

Despite these delays, however, one thing is clear: Hong Kong and China are inextricably linked. As more and more H shares list on Hong Kong’s stock market, it is easy to see China’s growing influence on Hong Kong. But Hong Kong is undoubtedly having a different but equally important effect on China, providing both a template and a mechanism for the liberalization of China’s markets. The special region remains the gateway to China for most foreign investors, and it is increasingly a gateway to the world for Chinese companies (and possibly Chinese investors as well).

Many changes seem likely in the coming years as China’s unprecedented growth continues and it flirts with world power status; its relationship with Hong Kong will be a key factor in its economic development.

“As China flirts with world power status, its relationship with Hong Kong will be a key factor in its economic development.”

A Window On The Market
Hang Seng Indexes Company Limited (HSI) a Hong Kong-based index provider that is a subsidiary of Hang Seng Bank, has a front-row seat to history as it is being made. It has developed a broad family of indexes to chart the performance of both Hong Kong and mainland China’s markets.

With its multiple types of shares, its complicated relationship with Hong Kong and its exuberant growth, China can be a bit of a muddle to would-be investors. However, HSI has devoted itself to teasing out the knots to uncover the threads underlying the economies of both markets. Not only does it provide benchmark, blue-chip, size and sector indexes for the Hong Kong market, it also offers separate indexes for H shares and for mainland China’s markets.

HSI’s flagship index is the blue-chip Hang Seng Index, which has tracked the Hong Kong stock market since 1969. Among the other offerings in its index family is the Hang Seng China Enterprises Index, which tracks H shares on the Hong Kong stock market, and the Hang Seng China AH Premium Index, which tracks the spread between the prices of A and H shares for companies with both types of shares on the market. Taken together, this sample of three of HSI’s indexes can be used to paint an interesting picture of the developing relationship between Hong Kong and China, and of the growth of China’s economy in general.

The Hang Seng Index

“The Hang Seng China Enterprises Index offers the best way for foreign investors to capture the performance of China’s extraordinary growth ...”

The Hang Seng Index, one of the world’s best-known and most widely quoted stock indexes, is nearing 40 years of age. It is a blue-chip index with components selected based on size, turnover, sector representation and financial performance. Lately, the Hang Seng has been hitting new highs, and it cracked the 30,000 milestone in late-October. It has also undergone a few changes over the years, such as a bump in the maximum number of components to 50 this year and, in 2006, the application of free-float market-capitalization weighting and a 15 percent cap on the weights of individual components at rebalancing. The 2007 rebalancing was completed on November 7 and was scheduled to take effect on December 10.

Since 1997, the year of the handover, the Hang Seng has risen roughly 130 percent. In that time, the index has evolved into one that has a stronger financial sector—roughly 43 percent of the index, based on the rebalanced component list, versus 33 percent in 1997—and a larger commerce and industry sector that now represents 43 percent of the index, up from less than 25 percent in 1997. Property companies have seen their weight in the index fall by more than half, dropping from roughly 23 percent of the index to less than 10 percent today. And although the number of components included in the Hang Seng Index has been expanded from 33 over the years to 43 as of December 10, 2007, the number of property companies has fallen from 12 in 1997 to just six today.

Part of this evolution is fairly recent and has to do with the inclusion of H shares in the index starting in 2006. With the increasing interaction between the two economies, it made less sense to exclude the H shares from the Hang Seng Index than it did to include them. In 2005, prior to the inclusion of H shares, the commerce and industry sector represented nearly 45 percent of the index, while financials were just 38 percent. Property companies and utilities also had slightly higher weightings. However, based on the most recent rebalance, there will be nine H shares in the Hang Seng Index, and six of them in the financials sector.

A look at the top 10 components of the Hang Seng Index in 1997 versus today offers an interesting comparison. Three of the companies are still the same, which is somewhat amazing given the changes that have taken place in the last decade: HSBC Holdings, Hutchison Whampoa, and Cheung Kong Group continue to hold strong positions in the index. Half of the top 10 components currently in the Hang Seng are financial companies, whereas in 1997, only two of them were. And there are no longer any utilities companies in the top 10 components; in 1997, there were three. However, mobile phone operator China Mobile is the index’s second-largest component at 13.07 percent of the index. Other companies currently in the top 10 include two oil companies, a life insurance provider and the Hong Kong Stock Exchange. The components from 1997 that are no longer in the top 10 include the three utilities, a conglomerate, two property companies and a bank. Four of the top 10 components—PetroChina, China Life, CCB and ICBC—are H shares, and three of those are financial companies.

By including the H shares in the Hang Seng Index, HSI has changed the index from a blue-chip index representing Hong Kong to a blue-chip index that offers a fuller representation of a foreign investor’s opportunity set in both mainland China and the Hong Kong marketplace. The index represents one of the most viable ways to gain exposure to China, both through the Hong Kong equities, which are seeing increasing influence from China thanks to measures like CEPA, and through the inclusion of the H shares, which comprise slightly more than 31 percent of the index. The Hang Seng Index is positioned perfectly to capture the evolution of China’s stock market as the trade barriers and other divisions between emerging China and established Hong Kong fall.

Hang Seng China Enterprises Index
The Hang Seng Index is complemented by the Hang Seng China Enterprises Index, which tracks the H shares listed on the HKSE; it comprises all 43 H shares included in the broader Hang Seng Composite Index, and serves as a proxy for the actual mainland China stock market.

From many perspectives, the China Enterprises Index actually presents a more realistic picture of the mainland stock market than the mainland indexes themselves, as foreign investors can move freely in and out of H shares. In contrast, stocks traded only on China’s mainland exchanges are in such demand by domestic investors (who are limited as to where they can invest their money) that they have become rather inflated and disconnected from the global market … and perhaps from fair value.

If the Hang Seng Index is positioned to track the convergence of the Hong Kong and mainland China stock markets, the China Enterprises Index offers the best way for foreign investors to capture the performance of China’s extraordinary growth as an emerging market that is well on its way to developing into a world superpower.

And while the Hang Seng Index’s growth has been respectable, the China Enterprises Index’s rise has been rather breathtaking, particularly in recent months. As of the end of October, the Hang Seng was up 120 percent since the start of 2005, but the China Enterprises Index was up 320 percent over that time period. In the first 10 months of 2007, the China Enterprises Index was up 94 percent versus a still-impressive 57 percent increase in the Hang Seng Index.

One of the most interesting aspects of the Hang Seng China Enterprises Index is the way the top 10 components have changed over the years. Unlike the Hang Seng Index, none of the top 10 components from 1997 are currently included in the top 10. In 1997, many of the companies were transportation-related, with three airlines, a railroad and a shipping company. Those five companies together represented roughly 24 percent of the total index. The obvious explanation for their strong presence was that manufacturers exporting goods from China were heavily reliant on transportation companies. In addition, another three companies in the top 10 were energy- and power-related; they represent a total of roughly 21 percent of the index. Again, their presence is not surprising, as they were likely fueling China’s burgeoning industries.

As of the end of the third quarter, 2007, the seven financial companies in the top 10 components of the China Enterprises Index represented approximately 44 percent of the total index. This trend was hinted at in the Hang Seng Index, where H shares financial companies have a strong presence. With China’s economy having undergone a relatively long period of sustained development, it makes sense that financial companies would come to represent a larger part of the market; as wealth is generated, the need for financial services to support the growth of industry increases. The three remaining companies in the current top 10 are involved in oil and coal mining and power generation, reflecting China’s continued reliance on natural resources and fossil fuels.

Both the domestic and international sides of mainland China’s stock market have seen prices boom, but the China Enterprises Index’s rate of growth has been more realistic, reflecting China’s stupendous economic growth in the context of the global economy.

Hang Seng China AH Premium Index
If there were any doubts about a bubble in the A shares market, HSI’s recently introduced AH Premium Index effectively put them to rest. The AH Premium Index measures the spread between the A and H shares of companies with dual listings on the HKSE and one of the mainland exchanges. Currently, the index has just 34 components. An index level above 100 indicates an A shares premium, while an index level below 100 indicates an H shares premium. Although there is not much calculated back history, data going back to just 2006 shows a paradigm shift in the index’s behavior recently.

In 2006, the index indicated an H shares premium for 43 percent of all trading days. However, in 2007, there have been no such days so far, and as of the end of October, the index was indicating an A shares premium of roughly 54 percent. While this recent level may seem extreme—remember, this is the valuation premium for the same companies’ shares trading in the two markets—consider that the premium index went so far as to indicate an almost 84 percent premium on A shares in mid-August. On that same day, the index hit an intraday high of 197.82, indicating an A shares premium of almost 98 percent.

Coincidentally or not, the mainland government announced its plan to begin allowing mainland Chinese to invest in the H shares market just as the index hit its peak, and the index began trending mainly downward after that. This isn’t really surprising: Should mainland investors be allowed to invest in H shares, it would be like the loosening of a pressure valve; mainland investors would have more outlets for their investable dollars.

When the government announced the suspension of this program, however, the AH Premium Index indicated that the A shares premium jumped to a little over 60 percent in reaction, from just under 56 percent the previous trading day. It settled down to a 54 percent premium by the next day, but the premium remains.

Even with the A-shares’ premium shrinking, however, the AH Premium Index tracks a disturbing trend. The H shares as a whole are trading way above the Hang Seng Index, which is not at all alarming: China has experienced strong growth as an emerging market, while Hong Kong’s blue chips are displaying the steadier, more sedate performance of a developed market. However, pile another 54 percent onto H-share prices, and what was considered a remarkable growth story suddenly begins to ominously resemble a bubble. How China handles the opening of its markets and its economic policies in the future will help determine whether that bubble pops or deflates slowly.

As China’s growth continues and it takes further steps to open its markets, it is growing closer and closer to merging its economy with that of Hong Kong. The “one country, two systems” policy is going to be in place for another 40 years, but it is doubtful that China’s government wants to wait that long to bring the two markets into line with each other. The AH Premium Index gives both domestic Chinese and foreign investors a way to chart the eventual convergence of the two markets.

Hang Seng Indexes Company Limited
As the primary local index provider, HSI has demonstrated its expertise in monitoring and creating indexes capturing the economic opportunities that have been created by China’s development and its critical relationship with Hong Kong. Although larger global index providers offer indexes covering Hong Kong and China, the firm is uniquely positioned with a front-seat view of one of the world’s most unusual and exciting economic stories.

“How China handles the opening of its markets and its economic policies in the future will help determine whether the A-share bubble pops or deflates slowly.”

When considered as a group, the Hang Seng Index, Hang Seng China Enterprises Index and Hang Seng China AH Premium Index represent three key segments of that story. The Hang Seng is one of the world’s best-known blue-chip indexes, and it provides a window on the ways Hong Kong’s market is changing. The China Enterprises Index is important because it provides a more realistic measure of the value of mainland China’s stocks and provides a more detailed glimpse of what is becoming a more and more significant part of Hong Kong’s stock market. The AH Premium Index, by contrast, is not tracking a section of the market but a trend: Should the index stay close to 100 for an extended period, it is likely that the barriers separating the A shares and the H shares—and mainland China’s stock markets from the global economy—have been dissolved.

Eventually, Hong Kong and China’s “two systems” will be merged—with most of the merging likely to occur well before that 40-years-off deadline—and as the two markets delve into the uncharted territory before them, HSI is providing quantitative ways to track their progress.

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