The surge of Mainland stocks and reform of the Hang Seng Index

Since the end of 2005, Mainland stocks have staged a strong upward trend, as reflected in the more than 30 percent increase of the H-share index. This can be regarded as the continuation of the third bull-run started in 2003. (The last two were seen in 1993 and 1997 respectively.) Accompanying the surge has been China's economic growth supported by industrialisation and urbanisation. Signs of overheating and the resulted macro-measures had given rise to market adjustment in 2004, but these were short-lived. As positive developments reappeared in late 2005, Mainland stocks resumed rising. Optimism was further fuelled by the revision of China's GDP statistics.

According to the rules specified by the Hang Seng Index Services Ltd., as long as the Mainland enterprises completed their shareholding-restructuring (the Split Share Structure Reform of Listed Companies) and allow for full circulation of shares, they would qualify for selection as component stocks of the Hang Seng Index, on the same footing as domestic companies. Since the market capitalisation and turnover of Mainland stocks have already reached 15.8% and 26.5% of the totals of the main board, the reform of the Hang Seng Index is only a ratification. Otherwise, the Index's reference value would decline.

In light of the large market capitalisation of major Mainland stocks, which were also market leaders in China, it can be anticipated that more and more qualified H shares would enter the Hang Seng Index, after completing their shareholding-restructuring. In contrast, as nearly all domestic huge conglomerates have been listed, capitalisation of local stocks can hardly be boosted substantially. The role of Mainland stocks in the Hong Kong stock market should therefore enhance further.

Influence on the Market

The growing significance of Mainland stocks would be reflected in the following areas.

Concerning Hong Kong's market structure, it would become more diversified in terms of lines of business and more associated with the Mainland in terms of geographical background. The composition of the Hang Seng Index has long been an indicator of the structure of the stock market. The fall of properties and the rise of financials evidenced Hong Kong's economic restructuring. The subsequent inclusion of red chips and the coming admission of H shares signify Hong Kong's further integration with Mainland economy. So far, Mainland stocks listed in Hong Kong are more concentrated in natural resources and heavy industries, signifying the emphasis of China's economic development. Yet, as China boosts consumption and the service sector, particularly finance, Mainland stocks listed in Hong Kong would become more diversified.

Concerning the market movement, China's economic performance would increasingly influence the Hong Kong market. While contributing to the market's growth, this would also aggravate its risks. As long as the Mainland economy remains stable, amid the instability in the global market, it can add support and sustain confidence to Hong Kong's stock market. More support, however, should come from the huge growth potential of a developing economy like the Mainland, which could add new momentum to a matured market like Hong Kong. But inevitably, this would also be accompanied by risks associated with the instability and uncertainty during economic transition in the Mainland. Besides, with the reform in the Mainland stock market, e.g. shareholding-restructuring, the function of the Mainland stock market can be expected to normalise, therefore, stock market movements in Hong Kong and the Mainland are likely to be more interactive than before, with both increasingly count on the Mainland economy.

"Mainlandised" or Internationalised

Hong Kong's stock market has no longer been an accurate domestic economic barometer. Among the 33 component stocks of the Hang Seng Index, companies with international operations like HSBC and those operating in the Mainland like China Mobile have already occupied about 30% and 20% of the market capitalisation. This evidenced both "international" and "Mainland" characteristics. Growing symptoms of "Mainlandisation" recently has aroused the concern of the development of the market structure, or the decline of "internationalisation" in the Hong Kong market. This worry points to the relatively immature Mainland stock market and its relatively low corporate governance and supervisory standards.

Two points need to be emphasised here. First, Hong Kong's internationalisation, characterised by the listing of multinationals and investors from all round the world, would persist, so long as the highly free market system and quality operating system can be maintained. Second, there is no evidence showing Hong Kong's internationalised market has been negatively affected since the listing of H shares in the 1990s. On the contrary, the ability to capture gains from Mainland's economic development has contributed to attract global investors to Hong Kong. In other words, the Mainland factor has actually become a positive attribute for the internationalisation of Hong Kong's market. Further, as China liberalises its external investment in the future, appearance of Mainland investors in Hong Kong would consolidate Hong Kong's status as centre for international investment and finance. It can thus be said that "Mainlandisation" has become part of Hong Kong's internationalisation.

Worthy of attention, though, is Mainland's reform progress. Hong Kong's role as an intermediary for investing in China has been built upon the restricted access to Mainland's stock market as well as the latter's malfunction of raising funds. With the authorities' determination to reform, as demonstrated in the shareholding-restructuring reform, the Mainland stock market's ability to raise funds may resume quite soon. Limits to QFII have also been raised successively, and qualified overseas investors will be permitted to become strategic investors in newly listed companies or A stocks that have completed shareholding-restructuring. Besides, calls for restricting overseas listing have increased recently. Hong Kong should be aware of the challenge to its role as a substitute.

In fact, with the RMB15 trillion deposits in China's banking system as well as the potential huge capital inflows, given consolidating market confidence, it can be envisaged that supply of funds should not be a problem in China's market. Facing such a situation, Hong Kong should strengthen its more advanced role in enhancing the Mainland companies' corporate governance and stock market operating mechanism, apart from being a fund raising intermediary. This can better meet the Mainland's demand. Hong Kong's supervisor, intermediaries as well as investors should pay more attention on this area, e.g. designing specific supervisory methods for Mainland registered companies or co-operating with the Mainland in supervision. This should better help maintain Hong Kong's attraction to the Mainland and its international status.

As the Mainland stock market would gradually mature, Hong Kong would not act as its "substitute" forever. Instead, Hong Kong's prospects should rest on its complementary role with the Mainland. Being a sizable economy, the Mainland would probably not attain the degree of openness and freedom comparable with Hong Kong. Retaining such absolute advantage, Hong Kong should spend more effort in financial innovations, particularly in derivative products and the development of the Growth Enterprise Market.