Volatility sees capital flow from China in to Hong Kong

Stock Connect, the initiative connecting the Shanghai and Hong Kong stock exchanges, is witnessing a growing surge in capital exiting China into Hong Kong rather than the other way round, as volatility on the mainland continues to alarm investors.

In January 2016, capital flows into Hong Kong from Shanghai exceeded the flows into Shanghai from Hong Kong for the first time. This is despite many assuming Stock Connect capital flows would be biased towards Chinese A shares rather than listed Hong Kong securities. The Institute of International Finance estimated capital outflows from China hit $676 billion in 2015 amid widespread market volatility.

The calendar year began badly in China when share trading was suspended following the introduction of circuit breakers, which are designed to stop trading in volatile markets. These circuit breakers simply exacerbated the selling as investors sought to offload their equities before the breakers took effect.  Many investors have also expressed alarm at the rapidly depreciating RMB.

The market volatility has discouraged foreign investment in China. Some UCITS managers are particularly concerned. A growing number of UCITS have invested into the Chinese equity markets following announcements by the Central Bank of Ireland (CBI) and Luxembourg’s CSSF that UCITS could use Stock Connect.

However, there are concerns that some UCITS may have exposure to securities which may have been delisted or suspended from trading. This could present a challenge for UCITS with China exposures as many offer daily and weekly liquidity to clients. Furthermore, it could complicate striking accurate Net Asset Values (NAVs) as it would be difficult to value a delisted security.

Depositary banks, which are tasked with safekeeping assets, overseeing cash flows, and oversight, could face problems, particularly given the imminence of UCITS V implementation. UCITS V prevents depositary banks from discharging the liability for loss of assets or financial instruments to sub-custodians including market infrastructures such as Central Securities Depositories (CSDs) and Central Counterparty Clearing Houses (CCPs).

The volatility could make risk-averse depositaries nervous about working with certain UCITS with interests in China. There is a possibility that once UCITS V comes into play in March 2016, some depositaries could increase their fees. This could disproportionately impact China focused UCITS. Other depositaries may elect not to work with China-focussed UCITS if they feel the risks are too great.

Stock Connect became operational in November 2014. Initial trading volumes were low. This was primarily because foreign investors were nervous about pre-funding due to the different trade settlement time-frames for cash and securities in Shanghai versus Hong Kong. The settlement time-frame would have meant investors transferring securities to Shanghai from Hong Kong would have to wait one day to receive cash. However, global custodians have developed systems, which help reduce these counterparty risks. Since then, interest in Stock Connect has increased markedly.

There is even speculation that Stock Connect will be extended to Shenzhen at some point in 2016. Shenzhen’s exchange predominantly caters for small to mid-cap companies. There is belief that same day delivery for cash and securities may also be implemented in what would be a major boost for further Stock Connect initiatives. Some optimists even believe a Stock Connect between the UK and China is feasible. However, there are some hurdles to be overcome, such as the eight hour time-zone difference which could make trade settlement challenging.

Market experts have also said that a Bond Connect is feasible, which would provide linkages between the onshore and offshore corporate and government bond markets. Again, there are challenges. The on-exchange bond market in China is small with the majority of bond trading occurring bilaterally through the interbank bond market.

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