How linking stock exchanges will benefit China

A direct link has been established between Hong Kong and Shanghai’s stock exchanges. The so-called Stock Connect means investors in Hong Kong can now buy shares listed on the Shanghai Stock Exchange via their local brokers and vice versa. This is a milestone moment for China as it further opens the door to investors, liberalises its capital market and promotes the internationalisation of its currency, the RMB, through the two-way share dealings of investors in both markets.

Established in 1990, the Shanghai stock market has experienced a bamboo-dancing style development process in the last quarter century. After reaching a bubbly peak of 6,124 points in November 2007, the Shanghai Stock Exchange Composite Index crashed to its lowest point two years later at 1,614 points. Although it has recovered now to more than 2,400 points, the Shanghai stock market has been highly volatile over the past seven years.

Investors in mainland China have more or less given up hope in its stock markets for various reasons. Regulation has been inefficient or even counterproductive, government policies poor, with badly performing state-owned enterprises being dressed up to be listed in a short period of time. There are also problems of cheating in the industry in China, with insider trading, overstating of profits and performance commonplace, a lack of social responsibility on the part of listed companies, and irrational investor expectations.

To rebuild confidence in investors, China’s regulator, the China Securities Regulatory Commission, has tried implementing reforms to improve market efficiency and firm performance, but the results have been disappointing. This partly explains why in April 2014 China’s premier, Li Keqiang, announced that the Shanghai and Hong Kong Stock Exchanges will be linked as a new reform effort to strengthen the Chinese capital market.

Profound impact

The impact on China’s capital market may be profound. It will accelerate the internationalisation of the RMB and will support Hong Kong’s position as the largest offshore RMB settlement market in the world.

The new link will also enhance China’s ability to raise capital for the country’s economic and social development, as well as improving the competitiveness of both the Hong Kong and Shanghai stock markets in the world.

Finally, the legal and regulatory systems as well as the professional practices of the Hong Kong Stock Exchange will soon be adopted by its Shanghai counterpart. This will help restore confidence in the mainland stock markets. All in all the position of Shanghai and Hong Kong as two major financial centres will be strengthened.

Big opening

China has been gearing toward this since 2005 when the central government decided to liberalise the exchange rate of RMB in the hope that it will eventually become a world currency. Poor stock market performance and a lack of investor confidence mean that people in China do not have a reliable investment channel for their savings, leading to low economic efficiency for the entire national economy. It is hoped that the link will not only help the RMB to be more recognised globally but also restore investor confidence in the domestic stock markets.

This trading mechanism will open a huge window for China’s currency to flow through the stock markets. In the long term, shares in Hong Kong may even be priced in RMB, instead of Hong Kong dollars. Foreign investors will be able to gain access to the Chinese capital market through Hong Kong, so holding RMB will be similar to holding British pounds or US dollars.

The initial reaction to the news of this trading mechanism has been largely positive in Hong Kong and Shanghai. Hong Kong stocks were down on the first day, but the Shanghai Composite Index has risen more than 10% in the past two months. In the longer-run, we can expect this new link to boost the average daily value of stock trading, as well as marking another crucial step in the liberalisation of China’s capital market and desire to make RMB a global currency.

Published in collaboration with The Conversation

Author: Shujie Yao is a Professor of Economics and Chinese Sustainable Development at the University of Nottingham.

Image: Chinese 100 yuan banknotes are seen in this picture illustration taken in Beijing July 11, 2013. REUTERS.