Shenzhen Connect starts next week

…on December 5th.

That’s according to the Hong Kong Exchanges and Clearing Limited (HKEX), whose Stock Exchange of Hong Kong subsidiary signed an agreement with its Shenzhen counterpart on rules for Shenzhen Connect last month.  The agreement was just approved by mainland Chinese regulators.

what is Shenzhen Connect?

It’s a mechanism that allows investors in Hong Kong to buy or sell Shenzhen-listed stocks, up to a specified (but large) total daily limit.  It also allows China-based investors to buy and sell Hong Kong-listed stocks through the Shenzhen Exchange.

The start of Shenzhen Connect trading follows the successful establishment of a similar arrangement between Hong Kong and Shanghai, called Stock Connect, a little more than two years ago.


In a practical sense, Shenzhen Connect and Stock Connect together end the closed nature of the Chinese stock market.  Doing so is an important economic objective of Beijing.  It’s another step down the road to dismantling the central planning and control that has characterized Chinese socialism since WWII.

rising Shenzhen shares?

Will this signal a boom in Hong Kong interest in China-listed shares?  I don’t think so, but it will be interesting to watch and find out.

Stock Connect, which opened the Shanghai stock market to foreigners wasn’t such a big deal, in my view.  That exchange is dominated by state-controlled banks and by stodgy old industrials headed mostly by state functionaries with no idea of how to run a profitable business.  Beijing will protect the banks but is content to let the  gradually wither and die.  So I didn’t see any rush to be the first foreigner to arrive in 2014.

The Shenzhen Exchange, on the other hand, is home to much more entrepreneurial firms, with little or no official state involvement.  So, in theory, yes, I might want to participate.

A big roadblock for me, though:  I have no idea whether I can trust the financial reports that companies issue.

Two ways to find out: listen carefully to what local players say and do; and visit the companies that sound interesting, interview the managements–and then watch to see how what they say matches up with operating results and what the financials report.

Even then, my experience is that you may not be safe.  Years ago, I visited a small Hong Kong manufacturing company at the urging (I didn’t need much) of a friend.  The firm told me a fabulous story of its success making computers for children.  I went back to see the management some months later.  They didn’t recognize me as a person they’d spoken with before.  This time they told me an equally dollar-sign-filled story, but this time they were an auto parts firm.  Whoops.

I’m not willing/able to put in the effort required to understand how the stock market game is played in Shenzhen.  So, Shenzhen Connect won’t tempt me away from the sidelines.



cooling the Chinese stock market fever

In the 1990s, Alan Greenspan, the head of the Fed back then, famously warned against “irrational exuberance” in the US stock market, but did nothing to stop it   …this even though he had the ability to cool the market down by tightening the rules on margin lending.  This is the stock market  analogue to raising or lowering the Fed Funds rate to influence the price of credit, but has never been used seriously in the US during my working life.

The  Bank of Japan has no such compunctions.  It has been very willing to chasten/encourage speculatively minded retail investors by tightening/loosening the criteria for borrowing money to buy stocks.


We have no real history to generalize from in the case of China.  But moves in recent weeks by the Chinese securities markets regulator seem to indicate that Beijing will fall into the stomp-on-the-brakes camp.


–at the end of last month, the regulator allowed (ordered?) domestic mutual funds to invest in shares in Hong Kong, where mainland-listed firms’ shares are trading at hefty discounts to their prices in Shanghai

–highly leveraged “umbrella trusts” cooked up by Chinese banks to circumvent margin eligibility requirements have been banned,

–a new futures product, based on small and mid-cap stocks, has been created, offering speculators the opportunity to short this highly heated sector for the first time, and

–effective today, institutional investors in China are being allowed to lend out their holdings–providing short-sellers with the wherewithal to ply their trade (although legal, short-selling hasn’t been a big feature of domestic Chinese markets until now, because there wasn’t any easy way to obtain share to sell short).

What does all this mean?

The simplest conclusion is that Beijing wants to pop what it sees as a speculative stock market bubble on the mainland.  It is possible, however, that more monetary stimulus–to prop up rickety state-owned enterprises or loony regional government-sponsored real estate projects–is in the pipeline and Beijing simply wants to dampen the potential future effects on stocks.

I have no idea which view is correct.

It’s clear, however, that Hong Kong is going to be a port in any storm, and that it is going to be increasingly used as a safety valve to absorb upward market pressure from the mainland.  So relative gains vs. Shanghai seem assured.  Whether that means absolute gains remains to be seen, although I personally have no inclination to trim my HK holdings.



linking the Hong Kong and Shanghai stock markets

restricting foreigners

Every country has restrictions on ownership of assets by foreigners.  Some of this is unofficial, like when France said yogurt maker Danone was a crown jewel that Pepsi couldn’t buy, or when New York blocked Mitsubishi Estate from buying a decrepit Rockefeller Center.  Other limits–notably restrictions on non-citizens owning media or transportation assets–are set down in law.


It’s common that emerging countries restrict foreign ownership of all publicly traded locally owned corporations.  The same thing happened in Europe as it was rebuilding after WWII.  Two reasons:

–countries don’t want rich foreigners (translation:  Americans) to be able to scoop up valuable national assets for a song, thereby disenfranchising the country’s citizens and making locals into sort of tenant farmers, and

–they don’t want the potential disruption to economic activity (the currency and the money supply) caused by mad rushes in and out of local stocks by foreign portfolio investors.

two classes of stock

The most common method of controlling foreign ownership is for a country to establish two classes of stock, one to be held by locals, the other by foreigners.  The details vary widely country by country.  What makes China unusual is that, generally speaking, locals and foreigners trade shares in different venues–the letter in Hong Kong, the former on the mainland.

problems with the system

Whenever there are two different markets, and two different prices, for the same security, the party that gets the lower price is going to be unhappy.  Given that the supply of foreign portfolio capital is large and the number of foreign-designated shares is typically small, it’s almost always the local citizen who feels disadvantaged.

In addition, raising new equity capital can be awkward.  Foreigners may balk at having to pay, say, twice what a local does to buy a new share.

Invariably there’s unofficial arbitrage between the two classes.

In China’s case, it’s possible that Beijing wants inefficient state-owned enterprises to be more subject to the goad that can be provided by professional portfolio managers.

Shanghai/Hong Kong trading opened this week

This week, China opened limited foreign trading in Shanghai-listed stocks (not Shenzhen stocks, however, which make up about 40% of China’s market cap).  It is also permitting limited trading by mainland citizens in Hong Kong.  The control mechanism being used is daily limits on the cross-border flow of money in and out of both markets.  The system is called Stock Connect.

ho-hum, so far

The plan was announced a while ago–the result being that stocks identified as possible targets for fresh money in both Shanghai and Hong Kong were bid up in anticipation in recent weeks.  However, the volume of cross-border trading has been low and highly touted beneficiaries have been selling off.

For China, this initial indifference is probably the best possible outcome.  Still, this is another step in opening Chinese financial markets to the world.  And one day the ability for us to buy mainland stocks may be important.  It’s just not today.



China the largest economy in the world? ..that’s what the World Bank is saying

The World Bank has just released the findings of its International Comparison Program, derived from analysis of world economic data from 2011.  This is an update of the ICP results from 2005.

The data show that three years ago the US economy was only about 8% larger than China’s.  Given that China is growing by at least 7% per year while the US is barely expanding at all, the implication is that sometime in 2014 China will seize the #1 crown the US has worn since 1872 (according to the Financial Times).  That’s when the US surpassed the UK.

Generally speaking, the report shows the increasing prominence of emerging economies, especially in Asia.  That’s really no surprise, since that continent is home to two giants, China and India (#3 in the world).  In fact, the only news in the ICP report is timing.  Prior to this, and based on the earlier ICP data, most economic observers had expected China to pass the US within a few years.

Two caveats:

–the figures are based on total GDP.  Per capital GDP is still much higher in the US than in China, but the latter has over 4x as many people.

–the numbers are calculated using Purchasing Power Parity (PPP), not conventional GDP measures.

The difference?

Up until about a quarter century ago, economists took local currency GDP figures for each nation and converted them into a common currency, usually the US$, for comparison.   They used market exchange rates to do the conversion.  In the 1980s, however, people began to notice that this method was giving out crazy results.  China, for example, was growing at maybe triple the rate of the US at that time–but conventional GDP showed it shrinking relative to the US.

That’s how economists realized that measuring GDP through the ability to purchase internationally traded goods (which is, after all, what the exchange rate shows) wasn’t good enough.  So PPP, which measures the cost of purely domestic goods and services–like haircuts or movie tickets–as well, was born (you can find more detail in this post).


It’s probably more social and political than directly relevant to the stock market.  On the other hand, it reinforces the fact that the health (or not) of the Chinese economy is of crucial importance to the rest of the world.  As investors, China is too big, and too fast-growing, not to try to have some exposure to.  The clear way to do so, in my mind, is through Hong Kong, which is the destination of choice for legitimate Chinese firms seeking a listing that will attract non-mainland investors.  My impression is that not many US investors have been willing so far to put in the time and effort needed to learn about it.


Tomorrow Keeping Score returns, after a month’s hiatus.




Hong Kong stocks–trying to turn up?

early signs from Hong Kong

Over the past couple of weeks, property stocks in Hong Kong are up sharply.  What makes this interesting is that in that market, property stocks and trading conglomerates (the successors to the old British opium companies) are the main ways of playing a cyclical upturn there.

economic policy stances

Describing the present situation in world markets in the most basic terms, we might say that the US and the EU are trying to deal with structural problems that are being made somewhat worse by a cyclical downturn in trade with emerging markets.

China, on the other hand, is dealing with a cyclical domestic downturn induced by government policy, which also is being made somewhat worse by the structural issues its Western trading partners are facing.

The US adopted an accommodative money policy years ago to address its problems, but appears unable so far to make any supportive fiscal changes.  The EU is very belatedly beginning to move on both fiscal and monetary fronts.

China has recently begun to reverse its restrictive interest rate regime, as its economy has begun to slow markedly.

China’s moves already making a positive difference?

That’s what the stocks of Hong Kong property developers appear to be saying.  It’s possible that property stocks are only moving in anticipation of future economic growth and not in reaction to the first stirrings of that growth itself.  My hunch is that the latter is the case, because I don’t read any world markets as being confident enough to act on policy changes alone.

Nevertheless, it’s still early days–too early for all but the most aggressive investors to act.  But the property stock movement does bear watching.  If Beijing’s policy efforts are already beginning to kindle even a mild cyclical upswing in the Chinese economy, there are two positive implications for equity investors.

–Hong Kong stocks, and especially pro-cyclical, China-related sectors like property, would continue their recent outperformance for a considerable time to come, and

–companies listed in other markets which have important China exposure and which have been languishing recently–luxury goods makers, for example–would likely become attractive investments again.

Bill Ackman: buy the Hong Kong dollar for revaluation potential. Does this make sense?

the Ackman investment idea

Bill Ackman, the hedge fund manager behind Pershing Square Capital, delivered a keynote address at a CNBC investment conference on Wednesday, September 14th.  In his remarks, he suggested that investors buy the Hong Kong dollar.  He expects that currency, which has been pegged to the USD for the past 28 years, will soon be revalued upward.  One possible revaluation target is the Chinese renminbi (Hong Kong is, after all, basically a province of China; another would be a basket of currencies representing Hong Kong’s trade flows (which is what many smaller countries move to when they unpeg from the greenback).

Pershing Square has already acted on this idea.

his reasoning

I didn’t hear his talk, but I did see his subsequent appearance on CNBC to explain his thinking.  He has two points:

lots of potential upside, no downside

–by buying one-year options on the HKD you can get 25x leverage.  If you used .5% of your capital to buy options and the HKD were repegged against the USD at a level 30% higher, you’d make a profit of more than 10% of your capital.  Against this huge gain, the downside is tiny:  you lose  the .5%.

the peg isn’t economically justified

–when a small country pegs its currency to another nation’s, it has to keep its short-term interest rates in line with the other country’s.  US interest rates are at zero,  as we heal from the massive damage done by the financial crisis.  For Hong Kong, which is growing strongly, a zero interest rate policy is massively over-stimulative and the source of destructively high levels of inflation.  Therefore, a move to a more appropriate exchange rate is likely.

is that it?

Pretty much.  Mr. Ackman also says he’s studied the history of Hong Kong carefully and that in”similar circumstances” Hong Kong has changed its peg.  It’s hard to believe he’s serious about that, though.  I don’t see how any decision a colonial governor might have made several decades ago in support of the interests of the UK would cast any light on the decision Beijing might make today in support of its own national interest.

Mr. Ackman’s reasons aside,

what could go wrong?

Pegs are usually motivated by economics.  Not in this case.  The Honk Kong peg is all about politics.

1.  The current peg was introduced to stem massive outflows of money from Hong Kong when Beijing and London announced in 1983 that Hong Kong would be returned to the mainland in 1997.  Given that many Hong Kong citizens had fled from China after WWII, losing all their possessions doing so, something had to be done to lessen the fear of a repeat.

Hong Kong citizens have long since come to understand that hitching their star to Beijing was the luckiest thing that ever happened to them.  So avoiding panic selling of the HKD is no longer a reason for having the peg.

2.  The inflationary buildup caused by the peg, almost from its onset, forced traditional Hong Kong industries like textiles, garments and electronic assembly out of the colony and into the mainland–initially into the nearby Special Economic Zone of Shenzhen.  In other words, it expedited the technology transfer that Beijing desired to hasten the mainland’s industrial development.

In this regard as well, I think the peg has long since outlived its usefulness.  Cost differences are still a motivation for having as much as possible of the management and administrative structure of a firm on the mainland, though.  And  that has forced faster infrastructure development in the major eastern urban areas.

However, I think there’s still a reason that Beijing would like to keep the HKD/USD peg.

3.  Beijing has made it clear that it wants the renminbi to become an important international currency, perhaps one day an alternative to the USD as a reserve currency for the world.  China has put a tremendous amount of effort into furthering this goal over the past couple of years in, for example, the way it has structured bilateral trade agreements and in the way it is fostering Hong Kong as a center of offshore renminbi finance.

Making the HKD a more attractive substitute for the renminbi doesn’t advance this effort.  It sets it back.  That’s why my guess is that a revaluation of the HKD dollar won’t happen.  If Beijing had its way (and it probably eventually will) the HKD will be supplanted by the renminbi, even in Hong Kong, and just fade away.

A much safer way of playing possible revaluation would be to buy Hong Kong stocks that have revenues linked to the renminbi and costs linked to the HKD.  But you’d stand to make a 20%-30% gain on revaluation, not the 2500% jackpot Mr. Ackman is hoping for.

will Hong Kong break its currency peg with the US$?–probably

the HK$-US$ peg

There has been increasing speculation recently that Hong Kong will abandon the policy, in place for almost thirty years, of tying the HK$ to the US$ at a fixed exchange rate.  Given the tenacity with which the former British colony defended the peg during the Asian financial crisis of the late 1990s (against speculators who seem to have had no clue about Hong Kong), this may seem strange.  But I think the peg has served its purpose and may now be more trouble than it’s worth.  My guess is the peg will go–and in the near future.  In stock market terms, this would be good for domestic firms that use US$ inputs and bad for exporters.

why the peg exists (much more detail in this post)

In the initial post-WWII period, the Hong Kong dollar was pegged for economic reasons, first to sterling and later to the US dollar. In 1974, however, the Hong Kong government decided to let the currency float.

Pegging your currency to that of your largest trade customer makes a lot of sense  for an emerging economy ( the granddaddy of post-WWII pegging successes is Japan), since it ensures that you retain the labor cost advantage that’s your greatest development asset. Doing so has a number of costs, however. One of the most significant is that you give up control of your domestic money policy. You can’t tighten when the other party is loosening, even though that might be the right move for your economy. Why not?  Your interest rates go up; the other country’s go down.  The higher interest rate differential means arbitrageurs short the other currency and use the proceeds to buy yours.  This produces immediate upward pressure on your currency and downward pressure on the other party’s.  So you’d be shooting yourself in the foot.

Therefore, you’re stuck mimicking the money policy moves of your key trading partner. Unless the developing economy is extremely vigilant and conducts a restrictive fiscal policy, the consequences can be disastrous. The most recent example of calamity can be seen in the current situation of Ireland and Spain, which imported a vastly over-stimulative monetary policy through the euro—where interest rates were set with an eye to the needs of much less dynamic members like France and Germany.  Ouch!

unpegging in 1974

In the mid-Seventies, the US was beginning a policy of too much monetary stimulus that would spawn a late-decade inflationary spiral—and the subsequent Volcker medicine (sky-high interest rates and deep recession) of the early Eighties.

Rather than be dragged along down the same path, Hong Kong unpegged.


In October 1983, however, Hong Kong repegged to the dollar. This had nothing to do with the now more orthodox money path of the US. The key reason was political.  The mainland refused to renew the lease the UK held over Hong Kong, meaning that the British colony would revert to Chinese rule when the then-current lease ended, in 1997.

At first, Hong Kong citizens weren’t thrilled. They had witnessed the ill effects of the Great Leap Forward and the Cultural Revolution, and surmised that they might well be the recipients of extensive “reeducation” to purge them of their capitalist views. Given that the state and the Communist Party owned all the capital, they might forfeit all their personal wealth, as well.  And the UK wasn’t appearing overly worried about the future safety of colony residents (Parliament would eventually deny UK citizenship to the mostly ethnic Chinese Hong Kong citizens, saying they would find the climate of the British Isles inhospitable).

Given this situation, Hong Kong citizens had two priorities:

–find another country willing to make them citizens and give them passports, and

–get as much accumulated wealth as possible out of Hong Kong and out of Hong Kong dollars (which might not exist after 1997).

when to move?

When should you remove you money from Hong Kong? Assume your HK$ would have no value after the handover. Your first thought might be to take your money out of Hong Kong a few months before the fact, to avoid the terminal collapse of the currency.  But everybody is going to be thinking the same thing.  So the date when the currency begins its swoon may not be in 1997 but maybe in 1996. But everyone is probably working that out, as well. So the currency will exhibit terminal weakness even earlier.  Who knows how many iterations of this backing-off process there will be.  The only sure thing is that the penalty for waiting too long will be severe.  Maybe the safest course, then, is to start to move money out of Hong Kong immediately.

To forestall a currency crisis that was already starting to ignite, the Hong Kong government decided to repeg. It though–correctly–that if citizens were guaranteed that their currency would not lose value vs. some internatinoal standard during the runup to the handover, capital flight would be minimized.  The penalty in imported inflation might be high.  But the political necessity overrode this.

the present

The pegging policy worked.

We’re now almost thirty years later. Hong Kong has survived the continual inflationary problems that the peg to the US$ have caused. Citizens have long since realized that the luckiest day of their economic lives was the one when China decided not to renew the UK lease.

So there’s no real reason in today’s post-colonial world to keep the peg.  All it brings is inflation–especially now, when the US is maintaining super-low interest rates as it tries to recover from the near-meltdown of the financial system. And Hong Kong citizens would by and large prefer to hold currency tied to the renminbi than to the US$ anyway.

My guess is that the rumors we’re hearing are a testing of the waters as prelude to replacing the peg.

investment implications

In all likelihood, the HK$ will rise vs the US$ if the peg is removed.  If so, the implications are straightforward.  Any firm with revenues in HK$ and/or costs in US$ will benefit.  Any firm in the opposite situation will lose.