The Link Between Hong Kong and Shanghai Stocks

Liberalization of stock trade responsible for Hong Kong rally
April 10, 2015 Last Updated: April 12, 2015

The Hong Kong stock market is up almost 10 percent for the week, after a flood of mainland investors stormed the Hong Kong stock exchange to buy up cheaper offshore issues.

Mainlanders weren’t always able to do this and it’s the Shanghai-Hong Kong Stock Connect program that lets them do it.

This complicated diagram illustrates two things: Investors based in the mainland can buy some Hong Kong stocks and the other way around. The program was devised by Chinese Premier Li Keqiang and launched on Nov. 17, 2014, with the long term goal to integrate the two capital markets.   

A diagram depicting the working of the Shanghai Hong Kong Stock Connect program (Shanghai Stock Exchange)
A diagram depicting the working of the Shanghai Hong Kong Stock Connect program. (Shanghai Stock Exchange)

This makes sense as Chinese stocks like PetroChina Ltd. trade both in Hong Kong and Shanghai but often have different prices. This is the same as if a U.S. stock trading in Los Angeles and New York would have a different price.

So far, Hong Kong stocks were cheaper than mainland issues because investors in the Hong Kong market are generally professionals who know how to assign the proper valuation to a stock and compare it to international peers.

In financial markets, however, these are exactly the 10 marginal percent it takes to move prices higher.

In mainland China, many investors are not very educated, are prone to use debt to buy stocks, and are also forced to buy them for the sheer lack of alternative investment products.

Curiously enough, the program wasn’t very successful up until recently. For 2014, only 21 billion yuan (US$3.4 billion), or roughly two times the allowed daily quota of 10.5 billion yuan was used by mainlanders to invest in Hong Kong stocks.

In March 2015, 26.2 billion yuan was used up, still far less than the allowed quota. Only starting Wednesday this week did mainlanders start to use the full daily quota. Why now?

The Hang Seng index of Hong Kong stocks after the close on April 10, 2015. (Google Finance)
The Hang Seng index of Hong Kong stocks after the close on April 10, 2015. (Google Finance)

For two reasons. First an article in the China Securities Daily paper advised individual speculators to buy Hong Kong stocks because they are cheaper than their mainland counterparts (24 percent on average).

Second, mutual funds from the mainland are also allowed to participate in the program and it seems it did not take them a long time to realize it’s better to buy the same stocks cheaper in Hong Kong.

Despite the success, the stock connect volume flowing into Hong Kong makes up less than 10 percent of the total trade on the Hong Kong exchange. In financial markets, however, these are exactly the 10 marginal percent it takes to move prices higher.