Premium Index Might Have Nothing To Measure Soon

September 19, 2007

Proposed changes in China might make HSI's premium index unnecessary—or at least less interesting.

It could be said that China is a market with too many investors and not enough stocks. With their foreign investment opportunities severely restricted, mainland China's investors are flooding the mainland stock markets with their investable cash, driving up share prices and creating what many have termed a bubble. Recent steps by China's government to open up the markets may at least partially alleviate the problem in the future, but for now, the problem remains.

Earlier, we reported on the launch of a new index family by Hang Seng Indexes (HSI) that featured an index measuring the valuation spread between the share classes of Chinese companies listed on both China's A-share market (reserved for domestic investors) and Hong Kong's H-share stock market (open to international investors, but closed to the domestic China market). (You can read the story here.)

Since late 2006, the A-shares have been trading at a premium to the H-Shares, and the Hang Seng China AH Premium Index measuring that premium has been on a mainly upward trend. There was a bit of a dip in the trend line this summer, with the premium bottoming out near 30% in mid-July, but that dip proved ephemeral. On August 17, the index hit a premium of 97% before dropping down to an all-time high close of roughly 84%. The following Monday, the Chinese government sent the index in the opposite direction with the announcement that it would be test-piloting a plan that would allow mainland Chinese citizens to invest in the Hong Kong market without capital constraints. The announcement resulted in the biggest two-day gain for the Hong Kong's Hang Seng Index in six years; the index rose 6.6% on expectations that domestic Chinese investors would pump money in the H-shares market.

The plan has since been postponed, but when it does go into effect, investors in the Tianjin Binhai New Area will be able to sign up for accounts with the Bank of China, which they can use to invest in the Hong Kong market. Most people believe that the program is likely to result ultimately in all of mainland China being allowed to invest in Hong Kong, which would create a natural arbitrage opportunity that would give the A-shares premium a limited life span. If mainland China's money starts flooding into the Hong Kong market, the A and H shares will likely achieve some sort of equilibrium in short order.

The Hang Seng China AH Premium Index has already started anticipating that possibility. It is trading well off of its high and is unlikely to reach those lofty levels again. Still, it hasn't disappeared: The premium has been hovering in the sixties for the last few weeks, closing last week at 165.34 (indicating a 65.34% premium), and it does not seem like it will make a definitive descent toward zero any time soon without an additional catalyst. It's likely that catalyst will come from the Chinese government, should it make a move to put the originally outlined program, or one like it, into action.

But conspiracy theorists could have a field day with the recent chain of events: Did China's government make its original announcement with the intention of derailing the growth spurt of the A-shares premium? It seems mighty coincidental that it came on the trading day immediately after the premium index reached a new high, but who knows? It could very well be that the government felt the need to announce the plan earlier than originally intended in order to check the growth of the ballooning A-shares premium.


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