Records set in total market cap, turnover and number of listed companies

By the end of 2004, the total market capitalization of Hong Kong stocks had surged to HKD6695.9bn or 4.5 times of the GDP. It beats 1997's pre-Handover record by 45%, and surpasses 2000's post-Handover record by 30%. When compared with the banking system's HKD3800.0bn in total assets and the bond market's HKD600.0bn in outstanding amount, Hong Kong's stock market is without a doubt the one capital market with the most depth. In relative terms, its 4.5x ratio of total market cap to GDP even overshadows the 1.3x of the New York and Nasdaq Exchanges combined.

Such sheer scale helped bring the market's total turnover last year to a record HKD3974.1bn. However, it was only fractionally higher than the previous record of HKD3789.0bn set in 1997. This implies that the activeness of trading in 2004 might not match that in previous record year. To verify this assumption, we divide the total turnover for the year by the yearend total market cap to reach a ratio that represents the activeness of trading. Based on such calculations, only 59% of stocks changed hands in 2004, relatively subdued when compared with the 118%, 64% and 64% recorded in the year 1997, 1998 and 2000. Nevertheless, it must be pointed out that the unusually active trading then was the result of events such as asset bubbles, the Handover, the Asian Financial Crisis, and the Government's intervention, etc. Therefore, the market was actually much healthier in 2004 even though trading was less active.

The rally in the overall market and more companies being listed help explain the records set in aggregate market cap and turnover. In 2004, the Hang Seng Index (HSI), which accounts for 70%+ of the total market cap, rallied 13%. And the Hang Seng Composite Index, which accounts for 95%+ of the Main Board's market cap, also rose by 13%, contributing most to the 22% increase in the aggregate market cap. Moreover, Hong Kong's stock market continued to expand. The number of listed companies on both the Main Board and the GEM Board climbed to a record 1096 last year, up 6% from 2003. As many newly listed companies were Chinese enterprises with sizable market cap, they helped launch the overall market's expansion.

Other important achievements

Beside the major records mentioned above, more were broken in terms of trading value of H shares, derivative warrants, the number of newly listed derivative warrants, the number of futures, options, stock options and the Hang Seng Index futures contracts. The cash and derivative markets fared equally well, setting the general market in a mutually beneficial interaction.

As the result of a flurry of records, Hong Kong's stock market, with total market cap at USD846.5bn, became the ninth largest in the world according to the World Federation of Exchanges. It was only trailing the eighth seated Spain Exchange by 6%. But if taking into account of the Euro's 6% appreciation against the US dollar and the HKD's peg exchange rate, Hong Kong's stock market should have commanded roughly the same size as Spain net of the exchange rate effect. Under a city economy, Hong Kong's stock market, with its dynamism, depth, reputation and free and open principles, should remain a favorable destination for international capitals and sustain long-term superiority.

At the fund raising front, IPO last year raised HKD95.8bn, second only to the year 2000's record of HKD132.1bn. Combined with post IPO funds raised, the amount totaled HKD270.9bn, ranked 3rd in the world behind New York and Spain Exchanges. Although it still lagged behind the seemingly insurmountable HKD467.3bn raised in 2000, it surpassed 1997's record. The market also maintained the 2 to 1 historical ratio of post IPO funds raised versus the IPO funds raised, demonstrating the super depth of its secondary market. Thus the successful co-developments of both the primary and the secondary markets should bode well for further endeavors.

But no record for the HSI

Against those records, it was the Hang Seng Index's failure to make new high that stood out. It closed at 14230.14 at the end of 2004, some 22% below its historical high of 18301.69 registered on March 28, 2000. Why is there such divergence in performance? The answer lies in that the number of listed companies continues to grow, but the HSI constituent stocks continue to change, and there are restrictions for their selections.

Firstly, as more companies are listed, the total market cap and turnover are bound to grow, with or without the index rising along. Hong Kong's advantage as the primary choice for IPO in Asia is only loosely connected to the performance of its market. From the year 2000 to 2004, the number of listed companies grew by 39% to 1096, propelling the total market cap up by 30%. But since 2000, a bear market that lasted for more than three years had plagued Hong Kong, resulting in declining share prices and the Index, and thus the divergence in performance.

Secondly, the constituent stocks of the Hang Seng Index have undergone substantial changes over the years. Among the thirty-three stocks that pushed the HSI to historical high in March 2000, eleven or one third of them have been replaced since. Some new entrants were only listed between 2000 and 2004. And they have greater impacts on the aggregate market cap than on the Index. This is because when changes do take place, there is usually upward bias to the HSI as stronger stocks replace weaker ones. But whether the Index can make new high from then on depends upon the overall performances of all the constituent stocks. As many of them are still below their historical highs made in the year 2000, there is no wonder that the HSI is still struggling to make up for lost ground.

Lastly, as defined by the HKEx, the HSI constituent stocks must not be foreign companies. This controversial criterion excludes H shares because they are deemed foreign because of their Mainland incorporation. But many H shares are state owned enterprises that have greater market cap than many HSI constituent stocks. Therefore, the restriction also results in H shares being reflected more in total market cap than in the HSI, even though many of their prices are already higher than that in 2000.

The ever-growing China influence

A significant development in 2004 was the manifestation of China's impacts. Red chips, H shares and other Mainland private enterprises were playing an increasingly dominant role in Hong Kong's stock market:

• There were 304 Mainland companies, 28% of the total, listed in Hong Kong at the end of 2004.
• Their market cap topped HKD2020.5bn or 30% of the total.
• They have raised a total of HKD901.0bn since January 1993 in Hong Kong, accounting for 49% of the total.
• The turnover of Mainland companies' shares was HKD1665.1bn in 2004, 42% of the total.
• Six of the top ten most actively traded stocks were Mainland companies.
• IPO by Mainland companies raised HKD75.4bn or 79% of the total last year.
• They also accounted for eight of the top ten IPO last year, occupying the top five spots as well.
• The ten largest IPO in Hong Kong's history are all done by Mainland companies.

Such statistics suggest that the successful transformation of Hong Kong's stock market has to rely on the support of Mainland enterprises. In return, their choice to list and trade in Hong Kong bring substantial businesses and incomes to industries such as investment banking, commercial banking, accounting, and securities trading, etc. Hong Kong's financial sector is transformed, its prosperity enhanced, and its international financial center status consolidated. Meanwhile, Mainland enterprises are able to find top notched services in Hong Kong's professional and sophisticated capital market. Large amounts of funds are channeled into the Mainland to facilitate economic growth. And Hong Kong can leverage its world standard supervision, accounting, corporate governance and information disclosure to help Chinese enterprises conquer the global market and promote their market-oriented reforms. This strikes a win-win situation.

Opportunities and challenges ahead

The surge of China's influence on Hong Kong's stock market was the result of two forces. One is the expediting of reforms by China. The other is the capital inflows motivated by the RMB revaluation expectations into HKD assets with distinctive China concepts. In 2005, these two forces are likely to remain largely intact. China's policy to encourage overseas expansion resulted in numerous listings of power, telecom and insurance companies in 2004. And the year of 2005 is shaping up to be the year of bank IPO including mammoth state owned banks and joint-stock commercial banks. Forecasts call for the breaking of the old IPO record set in 2000. Of course, the performances of the global and Hong Kong's stock markets will determine the progress of these IPO. Judging from current developments, a major bear market or a hard landing of China's economy that may disrupt IPO activities is still far from a major risk. As for the capital flows issue, the recent remarks by Chinese officials calling for the RMB exchange rate to be kept basically stable at an adaptive and equilibrium level helped diffuse some of the revaluation expectations. As such speculations are short term in nature, unable to keep up with losing positions for long periods, they might retreat temporarily after failing to force the RMB to move. But as time passes by, it only gets closer to the RMB exchange rate reform. Thus, sooner or later money will revisit Hong Kong to place another bet on the RMB.

In the medium run, it takes time for Mainland enterprises to accomplish market reforms and adopt international standards. During this process, China's national and economic power will undoubtedly strengthen, benefiting Hong Kong's stock market accordingly. But in the long run, two distinctive trends may emerge. Hong Kong's stock market may be dominated by China shares, and it may face direct competition from both China and the international stock exchanges.

Just as Hong Kong's economic cycle is becoming more closely integrated with the Mainland's, it is not unthinkable that China shares will one day dominate Hong Kong's stock market, which will then become a market catering to both Hong Kong and China, and whose fortune will also be closely tied to China. Concerns may arise regarding its international diversity feature. But as long as Hong Kong sticks to the free market principle and imposes no capital control, it will remain attractive to international funds, and the international diversity of its investment funds will remain intact. In terms of listed companies, due to the maturity of Hong Kong's economy and markets, there will not be many large domestic companies waiting to be listed. In order to expand, Hong Kong must look beyond its border to the Mainland, Taiwan and Asia. And ultimately, it is the listed companies' conformity with international standards instead of their origins that determines whether a market is deemed internationally diversified. So long as Hong Kong successfully assumes the double roles of assisting Chinese enterprises to enter the global market and channeling global funds to the Chinese market, provides supervision and infrastructure supports to the Mainland, and strengthens its own advantages, there should be little worry about its international diversity. And as China further evolves into a capital exporter from an importer, Hong Kong stands to benefit from serving as a medium between foreign enterprises and Chinese capital, further boosting its international diversity.

When China largely accomplishes the market-based reforms, whether Hong Kong's stock market remains attractive to Mainland companies will depend upon whether Hong Kong can further raise the bar of market depth, quality, supervision and corporate governance and strengthen investors' confidence. Accomplishing these will ensure that when Chinese enterprises choose where to list their shares, the scale will still tip in favor of Hong Kong.