Mainland investors get rare chance to understand how a global stock market works

China celebrated a milestone in its stock market on Nov 17. Thanks to a landmark program called Shanghai-Hong Kong Stock Connect, retail investors in the mainland and Hong Kong, for the first time, are allowed to directly invest in each other's stock market.

Stock buyers are happy they have more choices, but the program's significance is far more than that.

Most important of all, this investment program promotes China's push to globalize the yuan and open capital accounts.

China has been promoting cross-border use of the yuan since 2008. After years of effort the currency has increased its popularity among overseas investors and governments, who have massive yuan holdings. But China's capital account and foreign exchange controls have made the use of yuan not particularly convenient. As overseas holders have very limited channels to invest their yuan holdings in China, globalization of the yuan is essentially a one-way street. Under the Stock Connect program, Hong Kong investors are now allowed to use yuan to invest in the mainland markets. So overseas investors can enjoy a convenient channel to invest their yuan in the mainland, facilitating the back flow of the currency.

In addition, as individual overseas investors are allowed to invest in the Shanghai market and as stock investment is subject to capital account management, the program naturally requires an opening-up of the capital account. Such an opening can grow larger with the expansion of the program in the future.

One day when the program expands to all overseas investors and to the whole of the mainland stock market, capital account controls on exchange and investment of the yuan are expected to be lifted.

The program is conducive to enhancing investor education on the mainland. The A-share market is rather isolated, running with its own rules. Earlier, individual mainland investors were not allowed to invest in overseas equity markets. The Stock Connect program presents a chance for them to test the international waters. It gives a rare opportunity for them to acquire the knowledge of how a global stock market runs and gradually gain the experience needed to invest internationally.

In many ways Shanghai and Hong Kong markets are quite different from one another. Hong Kong does not apply trading price limits on shares, but Shanghai does. Hong Kong's small-cap stocks are less active but small caps on the mainland are often subject to speculation. Other differences lie in aspects such as settlement and short-selling rules. Mainland investors will have to become familiar with Hong Kong rules. This is the first step for them to embrace the global markets.

Indeed, mainland investors still lack maturity. According to 1diaocha, a poll website, more than 80 percent of such investors say they tend to invest in stock markets by themselves instead of putting the matter into the hands of a fund manager or another institutional investor. Nearly 70 percent say they decide what stocks to buy by listening to what friends say or acting on other tips.

What is worse is that their awareness of risks is low. The mainland's stock market has a history of 24 years, and it experienced much fewer periods of ups and downs compared with major world markets.

Their risk awareness increased somewhat after the market turned bearish from 2008 amid the global financial crisis, but they are still far away from developing a long-term, rational and risk-cautious mentality. The Stock Connect program allows them to learn and improve by trying the Hong Kong market.

Moreover, the program can help reform the ailing and isolated Shanghai market. The crux of the problem is that the overall quality of listed companies is poor in this isolated market, causing an exodus of the best Chinese companies. Unlike in major developed economies, the best of the Chinese companies do not regard the domestic bourse as their favorite listing destination. More than 1,000 Chinese companies, or a quarter of those with A-share listings, trade their shares overseas. In contrast, only about 100 listed US companies have chosen to go public outside their country.

In China, the delisting ratio is no more than 2 percent, while it was 8 percent on Nasdaq annually, 6 percent on the New York Stock Exchange and 12 percent on the Alternative Investment Market in London. With bad performers staying on the domestic bourse and the good ones seeking listings overseas, the mainland stock market can only go from bad to worse.

The situation has resulted in two adverse effects. One is that investors have fewer choices to invest at home. Due to earlier restrictions in investing in overseas stock markets, Chinese investors cannot put their money in the best Chinese companies. The other is that mainland-listed companies do not care about investor interest since they do not need to face the competition of globally listed peers. No wonder small investors' interests are constantly ignored, supervision is poor and penalties for insider trading are light, making the A-share market an ATM for listed companies and big investors.

The Stock Connect program shatters this isolation by opening up the market for more world-class listings so public companies will strive to perform better to lure investors.

With individual mainland and Hong Kong investors able to invest in each other's market, a kind of competition and internationalization will be injected into the Shanghai market. Although the Stock Connect program is still in its initial stage, with limits on capital invested and stocks on offer, the isolation that protects mainland-listed companies is expected to be shattered. A-share companies will have to improve their governance and pay more respect to investors in the face of increased competition.

The program also boosts Hong Kong's status as a regional and international financial center. With two markets connected, what is obvious is that Hong Kong's position as the major offshore yuan center will be cemented. To develop the program, the Hong Kong Monetary Authority has scrapped the limit on the amount of renminbi local residents can exchange. The move is a great deregulation measure that will boost the use of the currency.

What is more important is that the program shows that central authorities cherish and trust the value of Hong Kong as a test ground for major financial reforms in the mainland. Earlier there was speculation that Hong Kong's competitiveness would become weak in the economy of greater China. This argument ran strongly especially when the mainland advanced its financial and investment opening-up with the launch of the Shanghai Free Trade Zone.

But the Stock Connect program now speaks volumes about the significance of Hong Kong. Thanks to its high degree of internationalization and its free economy, the city's role as a textbook for the mainland to acquire experience and as a proxy to link mainland and global markets cannot be replaced by other Chinese cities in the short to medium term. Although Hong Kong is losing out in sheer economic size and some traditional sectors such as exports and manufacturing, the city can still hold a vital position in China's economic landscape. The city's advantages, including internationalization, a sound financial system and low taxes, can become more prominent as the mainland's costs increase swiftly. For example, a migration of talent has emerged, with multinational corporations starting to base their medium- to senior-level executives in Hong Kong to avoid growing payrolls on the mainland.

As Guangdong province and Shanghai advance their financial opening-up, Hong Kong can provide the rich talent and capital and play a vital role in regional integration.

The authors are analysts at Universal Consultancy in Shanghai. The views do not necessarily reflect those of China Daily.

(China Daily European Weekly 11/21/2014 page10)