Intensified Coupling

Since late August, stock markets in Hong Kong and the Mainland have both experienced wide fluctuations. Initially, Hong Kong stocks climbed amid the U.S. rate-cut and probable implementation of "H.K. Stocks Through-Train" by the Mainland, while the bull run of Mainland stocks also accelerated. Since late October, the U.S. subprime turmoil together with diminished impact from Mainland funds have sent Hong Kong stocks down substantially, while Mainland stocks also staged the most lengthy and severe adjustments in the past two years. It is noteworthy that movements of stock markets in both territories have rarely been so close, with mutual influence evidenced. The influence of A share market performance on Hong Kong's market sentiment has been particularly obvious after November, while performance of the Hong Kong and international markets has also unprecedented influence on the A share market.

This can roughly be indicated by the higher correlation coefficient between the Shanghai Composite Index and the Hang Seng Index at 0.79 during August 20 - November 23, as compared to 0.64 during the first half-year. The coefficient was even as high as 0.94 for the first 17 trading days in November. To compare, the coefficient was -0.28 in 2005. Though the Split Share Structure Reform was implemented during that year, making it less comparable, it still serves to reflect the current intensified coupling between both sides.

New factors have arisen this year, which can explain the above development.

Firstly, major state enterprises have re-entered the A share market, making the profiles of listing companies in both markets more similar and enhancing the impact of H share companies in the Mainland market. In particular, PetroChina has occupied over 20% of the overall capitalisation of the A share market after its listing in early November. According to the statistics on November 20, the five stocks with the heaviest weightings in the Shanghai Composite Index, namely PetroChina, ICBC, Sinopec, China Life and Bank of China, which also have a presence in Hong Kong's H share market, have already had a combined weight of 47.2%. This undoubtedly demonstrates the increased influence by H share companies. The listing of PetroChina in the A share market may have prompted Mainland investors to pay more attention on the international market trend as the Company is more affected by global factors such as crude oil prices and worldwide economic cycles. This may have been a reason for the increased influence of overseas market on Mainland stocks.

Secondly, profits of Mainland enterprises, including those that have a listing in Hong Kong, have increasingly been affected by stock market movements. According to the Interim Corporate Results Analysis by the Shenzhen Stock Exchange released in September, as corporate profits surged, contribution from investment income increased by 50.19% while that from principal activities has fallen by 27.32%, when compared with the same period last year. This should be quite common to Mainland enterprises. As the Mainland stock market has risen even more since July, with the Shanghai Composite Index registering 50% increase, investment return resulting from mutual shareholdings among enterprises or actual stock investments would probably expand further. Besides, financial institutions would benefit from the increased transactions that generate more business for them. Corporate results and stock market movement have become mutually reinforcing. Mainland enterprises listed in Hong Kong would also be the beneficiaries, including the major banks and insurers that are leading H share companies.

In early November, the Hang Seng Index Services Limited announced the addition of three constituents to the Hang Seng Index, including PetroChina, China Shenhua and China Overseas. This increased the share of Chinese enterprises to over 50%. Currently, turnover of Chinese stocks has also occupied over 60% of the total. The influence of the Mainland stock market on Hong Kong should be obvious.

Thirdly, connections between both stock markets are expanding through the Mainland's gradual liberalization of capital movements . While ever growing connections between Hong Kong and Mainland enterprises have provided the foundation for enhanced stock market coupling, capital movement remained the major restriction. Any change in related policy measures is bound to bring about substantial impact. This year, capital outflow from the Mainland has accelerated, both by institutions and individuals, e.g. the expansion of QDII as well as flows through irregular channels prompted by the talks of "HK Stocks Through Train". Such development has also attracted international funds into Hong Kong. As China's economy has further gathered strength and gradually liberalised, its influence seems to have grown, particularly at a time when overseas markets have been clouded by the U.S. subprime problem and global investors are badly seeking targets.

With the Chinese stock market increasingly affected by international factors and the outflow of Mainland capital accelerating, the coupling between Hong Kong and Mainland stock markets would certainly intensify. For the Hong Kong market, A share performance would become another major external factor, in addition to Wall Street. The influence from the Mainland market would also be unique.

Policy factors and Investment Culture

As Mainland stocks have already occupied half of the Hong Kong market and Chinese capital is becoming more active, the issue of whether Hong Kong would resemble an "A share market" is naturally brought out. The recent high turnover and volatility of Hong Kong stocks and the influence of Mainland policies seem to have added to the Hong Kong market the characteristics of a "policy-directed" market as well as the culture of short-term trading against policy news.

Compared with matured markets, the Mainland stock market does appear to be "policy-directed", as there have been frequent announcement of official policies which have broad impacts. Related to the stock market, there are at least three aspects. The first concerns macro-economic policies, such as the macro-control measures. The second concerns the stock market directly, such as new listings, return of H companies, reduction of state enterprise shareholding, QFII and QDII. The third concerns any particular sector or enterprise, such as industrial policy, restructuring of monopoly sector, state enterprise reform as well as merger and acquisition or capital injection. Many ot these are rarely found in matured markets. As how they are implemented is not that clear, the actual impacts are hard to discount, giving rise to increased uncertainties.

From the above, it can be seen that the policies are much related to reform and liberalisation. This makes a "policy-directed" market a necessary characteristic in this stage of China's economic development. This would probably continue for quite a long period and investors should be prepared for it.

For Hong Kong, the impact of China's policy factors should not arouse much worry. In fact, Hong Kong has been familiar with this. The announcements of CEPA, Mainland's macro-control policy, the Federal Reserve's interest rate decision, that affect the global market and give rise to speculative activities, are all typical examples. As for the investment culture of the A share market, it should not be exaggerated either. Hong Kong has attracted investors from all over the world, and Mainland capital would only broaden its investor profile. The recent market volatility can be regarded as the result of divergent market expectations, which should be viewed as normal market forces. Besides, the Mainland investment culture has much to do with the dominance by retail investors, and would probably not infect a market composed mainly of international institutions like Hong Kong. In short, the policy factor and participation by Mainland investors should not alter the fundamental qualities of the Hong Kong market. To be more optimistic, the Hong Kong and international markets have already broadened the view of Mainland investors. Together with the accumulation of overseas investment experience, the Mainland market and investors could gradually become more matured.

New Issues

The following two issues that concern Hong Kong's market fundamentals are more worthy of attention.

The first one concerns the disclosure of information and insider trading. While the market can digest any policy influence, the lack of transparency or existence of asymmetric information among investors that give rise to injustice could be worrisome. This is especially probable since disclosure of policy decisions in the Mainland still lacks official guidelines and is bound to lead to market volatility, and hence bring about room for insider trading. As Mainland policies have increasingly affected Hong Kong and even the global market, and this may eventually influence China's policy effectiveness, the decision and execution of policies has become more demanding, and would certainly require more regularised and tactful arrangement of information disclosure.

As for insider trading, the Mainland's current regulatory framework still lags behind Hong Kong, with emphasis on attacking market manipulation. As impact of Mainland policies may be transmitted to Hong Kong through listed Chinese companies and Mainland investors, insider trading may become a by product. With derivatives widely available in Hong Kong that can enhance the return of trading, there may be more incentives for insider trading. The fact that such information is offshore and the possibility that related parties do not reside in Hong Kong would add to the difficulties of effective supervision.

The second issue concerns the influence of administrative authorities in the market. In addition to major policy changes, such as the Split Share Structure Reform, Reduction of State Enterprise Shareholding and measures of market liberalisation, administrative authorities may influence market movement in some occasions. Typical situations include the reference of listing decision, scale and momentum on market performance by the authorities. While these practices aim at stabilising the market, the government's role as regulator would be blurred by acting also as a market "tuner". Amid increasing connections between the Hong Kong and Mainland markets, such development deserves our attention. For the Mainland, it is worthy of devising measures to avoid influencing Hong Kong's market mechanism, so as to preserve Hong Kong's unique value as a matured, internationalised financial market.

Above all, the intensified coupling of Hong Kong and Mainland stock markets reflects the integration of both sides in certain aspects as well as Mainland's increased exposure to the external market. Investors should prepare for such development, while regulators from both sides should cooperate in tackling new issues. Should these issues be properly handled, the Mainland stock market would become more matured in its integration into the international market while Hong Kong would also benefit from such development.