Significant Divergence

With further economic and financial integration, the stock markets on both sides of the border become more comparable in terms of fund raising and trading volume. Their significant divergence in both categories challenges their relationship, capacity and positioning.

In Hong Kong, listed Chinese companies are mainly state-owned (H share) and red chips companies. Some of them are listed at the China A share markets as well, enabling comparison with Shanghai and Shenzhen A shares. As suggested by the relevant stock indices performance over years, A shares have been falling almost nonstop by double digits for most of the past five years. On the contrary, H shares and red chips in Hong Kong largely recovered and embarked on the rising track a couple years ago. They both outperformed A shares during the same five-year period.

Divergence in returns leads to divergence in multiples of the listed Chinese companies on both markets, narrowing the steep premium used to be enjoyed by A shares. Years ago, A shares dominated by trading at multiples much higher than their H share counterparts. Since then, the plunging stock prices resulted in lower P/E ratios, implying better corporate earnings of the underlying companies. Even so, A share investors are still on course of assigning lower but fairer multiples to them. Such adjustments are inevitable and even beneficial to A shares' long-term health. With the rising prices of H share and red chips in recent years, A shares' premium has markedly narrowed, with some even converged to that of H share. Because H share and red chips are trading in Hong Kong's open market, their share prices are the ultimate references to A share fair prices.

The weak A share market performance in the past several years has resulted in the contracting total market capitalization from RMB4745.6bn in 2000 to RMB3090.7bn in 1H05, or a loss of a third of the market value. To the contrary, as more Chinese enterprises are listed in Hong Kong, their total market capitalization nowadays has grown to HKD2054.7bn or about two thirds the size of China's domestic market. This is one of the most hotly debated controversies. Although the rise and fall of the market are largely driven by market force, the choice to list in Hong Kong and the ensuing formation of a liquid market raise concerns to Mainland's stock exchanges, investors and regulators.

All the concerns are manifested primarily on the divergence in total capitals raised for Chinese companies on both markets. The diverging trend in recent years finally results in Hong Kong H share and red chips raising more capitals in IPOs than China A share during the last eighteen months. The Mainland stock market reform related moratorium on new share sales as well as Chinese companies' own choices help contribute to such a result. Now the question becomes whether Hong Kong stock market developments are at the expense of the Mainland market.

Conflict of Partial Interests

The answer is a resounding No. Hong Kong's economy and financial markets are one of the freest and most open in the world. We do not impose capital controls and welcome enterprises and investors from any origins. As Hong Kong evolves into a matured economy, deals involving domestic companies in the IPO pipeline are naturally limited. Further developments require the expansion beyond its border. In Asia, Hong Kong has to compete directly against financial centers such as Tokyo and Singapore. Yet Hong Kong possesses a unique advantage, that is its close relationship with China in terms of connection, geography and culture. As a result, it remains the first choice for overseas listings by Chinese enterprises. Hong Kong satisfies such funding needs by attracting foreign capitals and investors to come to its open and advanced financial markets. For example, the majority of subscription comes from international investors when large state-owned companies are listed. This is the result of Hong Kong's comprehensive advantages rather than unfair competitions.

But still, the conflict of partial interests persists. As total market capitalization and funds raised diverge further in the two markets, the Shanghai and Shenzhen stock exchanges are rightfully worried about being marginalized, which is understandable. The lack of resources and deal volumes could be fatal and could mark the beginning of a vicious cycle. However, the causes are complicated, ranging from policy ones (such as moratorium on IPOs to reform the non-tradable shares even though hundreds of companies are waiting in line to be listed) to more fundamental ones of market capacity and investor confidence.

For individual and institutional investors including stock funds, social security funds, pension funds, and insurance funds, the impacts of Chinese companies deserting the A share market are also negative. They cannot directly invest in these shares that are only listed in Hong Kong due to capital controls, missing those of arguably the highest quality of Chinese enterprises. The lack of such top notched investment vehicles could hinder investor confidence and limit the developments of investment banking, brokerage, and fund management businesses in the Mainland.

The impacts extend further to the Mainland's stock market regulators. They are in a dilemma as on one hand, they are the ones who grant approvals to those companies wishing to list in Hong Kong. On the other hand, they also impose moratorium on new share sales in the Mainland. Nevertheless, there is no favoritism involved. Hard decisions have to be made regarding the Mainland stock market reforms as well as continuing to serve the development need. It is not a viable option to artificially restrict Chinese companies to list in Hong Kong because it can achieve little back home when there is confidence crisis and there is tremendous demand for capitals. The haunting issues affecting the Mainland's stock market is of institutional and structural nature instead of supply nature.

Conformation to General interests

Despite conflict of partial interests, Hong Kong stock market's undertaking to raise funds for more Chinese companies conforms to the overall interests of China when the Mainland market is undergoing critical structural reforms. Its role is vital.

The obvious divergence of Mainland's stock market from the rapid economic growth is not only puzzling, but also dangerous because of the malfunctioning of its fund raising capability could prevent the economy from reaching its growth potential. Yet, in the last three years, China's GDP growth has been above the 9% handle. As rapid economic growth comes with greater demands for capitals, China simply cannot afford to put its own growth at halt to buy time for its stock market reform. It is at this juncture that Hong Kong steps in and takes on the important financial intermediation role. Combining funds raised in both the A share market and Hong Kong stock market by Chinese companies, the total amount topped RMB/HKD100bn each year for the past several years, yielding a steady uptrend during the period.

But the question remains why Chinese companies choose to give up listing at the A share market with higher multiples and list in Hong Kong instead? Such a choice is not without rationale. In Hong Kong, the share price formed or discovered is a price universally accepted. Although at multiples lower than the A share counterparts, it is the price that Chinese companies have to face sooner or later if they are to venture beyond China. Moreover, the refinancing capability of Hong Kong stock market is as significant as IPO, which is vital to a company's long-term development. Then, it also enables the Chinese enterprises to adopt international accounting and corporate governance standards. Raising capitals may not be the only consideration of China companies. Take the state-owned banks for example, their preparations for IPOs involve offloading NPLs and receiving capital injections from the State, which usually run at amounts more than the funds raised from the market.

Besides, China's financial security issue also has to be considered. The Mainland stock and bond markets have yet to be well established, resulting in banks shouldering most of the financing burden for economic as well as corporate developments. The PBOC's latest report shows that in the first quarter of 2005, China's banks accounted for 99% of the capitals raised by companies domestically. The concentration of risks in the banking sector carries huge destabilizing potentials itself. Hong Kong in this case does its part to help diversify some of the risks by helping Chinese companies to raise funds. Although the ratio of its total market capitalization to GDP is well over 400% (China is at less than 30% and the US and Great Britain are under 100%), it is not a sign of extreme risk because of the major involvement and risk sharing by international capitals and investors.

Overall Development and Positioning

Without doubt, Hong Kong's stock market is handling more and more Chinese companies listings. Although this conflicts with the Mainland market's interests, it conforms to China's overall interests, making Hong Kong's stock market irreplaceable even when China further develops. From the national interests angle, Hong Kong is part of China and its stock market is also part of the Greater China market. It will continue to serve as an important conduit for Chinese companies to join the world. The so-called conflict of interests is actually a relationship of specialization and friendly competition. In the extreme case of irreconcilable conflict of partial interests, China's national interests have to be respected and served first. We are confident that the conflict of interests itself is transient and reconcilable.

The same could also be said regarding Hong Kong's overall positioning in China development. In recent years, there has been a sense of inferiority emerging in Hong Kong when comparisons are made against China rapid economic growth. In the Mainland, a sense of self importance has also developed, calling for discrediting Hong Kong's contribution to the Mainland developments and directly competition against it. This could lead to mismatches and wastes of resources. For the sake of China national interests, it should be avoided at all costs. The widely recognized advantage of Hong Kong lies not in cost but in its well-established system, with the latter being at the core of China opening and reform. Of course China can plot its developments around Hong Kong. But now that Hong Kong is China's Hong Kong, why not fully leverage on such a valuable asset instead of treating it as a liability? To do so can significantly lower the steepness of China learning curve and cost.

The relationship between the two stock markets should be on specialization and friendly competition. Hong Kong should take up more fund raising tasks when difficult reforms are underway in the Mainland market. Hong Kong should also actively participate in the reform design and construction of the Mainland market by introducing Hong Kong's systematic advantages to it. History tells us that Hong Kong also experienced a disastrous 90%+ plunge in stock prices during 1973-1974 period as well as long divergence between stock market and the economic growth. But it was against such a backdrop that foundations for solid infrastructures were laid and refinements are still being carried out today. The Mainland stock market seems to be at the same development stage. If it can take Hong Kong's lessons to heart, it should not have to spend the same long periods of time wandering and searching for the way out.

Even after the Mainland stock market has accomplished the market reform, vicious competition should still be ruled out for the two markets. Specialization in terms of internal and external financings as well as derivatives could still be feasible strategies. For the purpose of self-perfection, the Mainland market should develop all the capabilities of its Hong Kong counterpart. But this should not reach the point of one market's development is at the expense of the other. With China ever growing economy, two to three mature stock markets are required. As far as there is specialization, all the markets should be able to achieve decent growth.