Stock market access between Hong Kong and Shanghai is the precursor to more reform in China

The China Securities Regulatory Commission's decision to permit stock market access between the mainland and Hong Kong is likely to have a far-reaching impact on the Shanghai and Hong Kong bourses. Under the proposed plan, investors from the Chinese mainland and Hong Kong can freely invest in stocks listed in the reciprocal city.

Under the pre-stipulated quota, qualified investors from Hong Kong would be able to invest in stocks listed on the Shanghai Stock Exchange. At the same time, qualified investors from Shanghai could invest in stocks listed on the Hong Kong Stock Exchange. The quota, which is now set at 550 billion yuan ($88 billion, 64 billion euros) a year, is expected to fluctuate and eventually increase.

Bridging Shanghai and Hong Kong, arguably two of the most important financial centers of China now and for many years to come, will create tremendous opportunities. Be it the offshore renminbi market, the initial public offerings of mainland companies, or investors' diversified investment choices, Hong Kong provides important complements to both mainland investors and companies, and overseas institutions.

Allowing existing Hong Kong investors to access the A-share market offers several advantages to Hong Kong. For Hong Kong stocks and the Hong Kong Stock Exchange, such a move can greatly increase the Asian financial center's global competitiveness. Benefiting from the burgeoning economic growth and cross listing by many Chinese, especially red-chip high quality state-owned enterprises, Hong Kong has become a leading financial center. Not too long ago, it was the global leader in IPOs, thanks to block-buster deals from mainland companies.

However, things are changing rapidly. The tapering of the quantitative easing engineered by the US Federal Reserve has started sending chills through the emerging markets. With the withdrawal of capital from the emerging markets, there have been some substantial drops in market shares in Hong Kong.

Closer integration with the A-share market provides an opportunity to overcome this problem. With the direct investment channel, not only will international mutual funds and pension funds be given opportunities to invest directly in the Chinese mainland A-share market without having to take the detour route of Qualified Foreign Institutional Investors, but anyone with offshore renminbi to invest will get that chance, too. This way, Hong Kong will become the global securities trading center and a center for offshore renminbi trading and investment.

To be fair, allowing mainland investors to access the Hong Kong stock market may prove to be even more valuable. Given the control on capital accounts and cross-country listing, mainland investors are severely under-diversified in their portfolios. Such under-diversification costs mainland investors dearly, especially given the exorbitantly high volatility and recent disappointing performance in the A-share market.

By investing in the Hong Kong market, mainland investors can not only buy cheaper stocks offered by the same company (for most companies cross-listed between Shanghai and Hong Kong, the H-shares trade at a discount), but also invest in overseas companies that cater to Asian investors and are listed in Hong Kong.

With the direct investment channel between Hong Kong and Shanghai, mainland investors can use their existing accounts to invest in overseas companies. Such convenience and familiarity will no doubt boost mainland investors' confidence in investing overseas, which not only helps their portfolio performance, but also propels more Chinese capital into the international financial arena.

Companies listed in Shanghai also have reason to feel encouraged. Although not a bottleneck on the market, additional inflow of international funds will not hamper companies' stock performance. More importantly, the increment of international investors investing through their Hong Kong accounts can probably bring a shift in the minds of listed companies' management. Long-term, value-driven international investors may bring incentives to companies that have long term commitment to becoming better companies and rewarding their investors, and instill better discipline to companies with poor corporate governance and investor responsibilities.

With an increasing amount of international capital being allowed to invest in Shanghai through the direct mechanism in the future, it is conceivable that the mainland stock market will have to conform to international standard of emphasizing information disclosure and corporate governance. Otherwise, international investors will not be attracted and will eventually bail out of the market.

At the same time, their presence will motivate Chinese listed companies and the stock market to offer better protection to investors through a safe and more reliable investment environment, thereby pushing forward the long-awaited reform in Chinese capital markets.

Regardless of which city benefits more, it is clear that both should feel happy about the development. This may also settle the rivalry between Hong Kong and Shanghai to become the global center of China. If the two cities can become closely integrated with each other, at least in finance and investment, then maybe it does not make that much difference about which one of them wins. Both can win and China will be the biggest winner in further reforming and opening up its financial system and unleashing unprecedented productivity.

Another major beneficiary of this process is the renminbi. With China's increasing economic might and trade power, the renminbi is fast gaining acceptance with merchants and countries all over the world. However, holders of overseas renminbi have limited options to invest, because of the capital controls imposed by the People's Bank of China. This, undoubtedly, reduces some foreigners' interest in the renminbi as an investment currency.

The launch of the direct trading mechanism between Shanghai and Hong Kong will also serve as a breakthrough for capital controls. As long as foreigners can use their Hong Kong accounts to invest directly in mainland securities market, within the prescribed quota limits, they can also get the higher returns enjoyed by domestic investors. Such an expansion in the investment alternatives and improvement in investment returns will make the renminbi even more popular among China's trade partners and pave the way for the renminbi to become a truly international currency, for investment and reserve purposes.

Of course, no one can guarantee the progress will be completely sound and smooth. In fact, some risks and limitations can be expected along with the progress. Lack of familiarity may trigger some cultural shocks at first and even lead to disappointing performances. The determination of the quota is also a tricky question. A bigger amount may carry the benefits of extending the integration even further, but also runs the risk of destabilizing the other market. Finally, some are concerned that such integration may make mainland investors realize that the valuations in China's A-share market are unreasonably high by international standards, making it prudent to move the capital overseas. But that may indeed be an important component of such a reform move and eventually prepare Chinese the financial system to successfully integrate into the global financial system.

The author is a faculty fellow at the International Center for Finance, Yale University; and deputy dean of the Shanghai Advanced Institute of Finance, Shanghai Jiao Tong University. The views do not necessarily reflect those of China Daily.

(China Daily European Weekly 05/23/2014 page11)