It was a tumultuous day on July 8th in Hong Kong. The 5.8 percent collapse in the Hang Seng Index marked the sharpest one-day fall in the equity index since 2008. Meanwhile, on the Chinese Mainland, the country’s casino-like stock market continued its roller-coaster ride. Chinese Mainland equities have lost more than US$3.5 trillion value in less than a month – an amount equivalent to nearly 15 Greek economies. Vanished!
The context of the Chinese Mainland markets is important to understand the drivers of the dynamics we are seeing in Hong Kong, in our view. To summarise: late last year we observed the beginning of a sharp rally in Chinese Mainland stocks (see blue line above). This was primarily being driven by a build-up in margin lending to retail stock market speculators. It is unclear the precise reason why Chinese regulators encouraged such a sharp build-up in credit and subsequent stock market rally, though one credible theory relates to the need for indebted local Chinese governments to refinance their debts. By pushing stock prices up, this resulted in reduced earnings yields from stocks, which made the yields on local government debt more attractive – on a relative basis. That is, the stock market rally may have been used as a means to create demand for local government debt.
The problem, of course, arises when the bubble bursts – as it started to in June. Policymakers often forget that humans are wired in a way that makes them feel pain relatively more than an equivalent gain. Roughly 2.4 times more to be precise. Therefore, as perceived wealth evaporates, this can have very real consequences on human behaviour, particularly as it relates to consumption and investment decisions in the real economy. This, in turn, hinders the growth of the economy.
So in typical Chinese fashion, policymakers believed they could stop the bubble bursting by simply tinkering with a few rules – or more than just a few, as the futility of the exercise set in. Specifically, policymakers banned all new IPOs, capped short selling (and even tried to blame short sellers for the falling prices which is absurd), instructed pension funds to stop all selling and buy more stocks, while the central bank cut interest rates. In addition, over 1,300 companies suspended the trading of their shares equating to US$2.6 trillion in frozen value (equivalent to roughly 1.5 times the size of the entire Australian economy).
This behaviour by Chinese policymakers to effectively “close” their doors to public markets is a concept that would baffle many of us in the West, but is perhaps not a new idea in China. As economic observer George Chen recently pointed out, the legendary former Chinese leader, Deng Xiaoping, once said: “Stock market can be in capitalism or socialism. We should try. If we fail, just close it.” This is a scary idea and one of the reasons why we, at Montaka, have no intention in investing on the mainland any time soon.
Bringing it back to Hong Kong now, and the question remains: why did the Hang Seng Index collapse so sharply (see below)? Especially noting that the market is quite separate from the Chinese Mainland. We believe one of the drivers relates to the recent development of what’s known as the Shanghai-Hong Kong Stock Connect (commonly known as simply “Stock Connect”).
Stock Connect is essentially a market-access program connecting the stock markets of Hong Kong and Mainland China. There is a “Northbound” program facilitating investment into the Mainland from Hong Kong; and a “Southbound” program facilitating investment into Hong Kong from the Chinese Mainland. Quotas, set by Chinese policymakers, limit how much capital can flow between the two markets.
Now, it’s important to remember that many Chinese companies are listed on both the Mainland and in Hong Kong. Mainland shares are known as “A-shares” while shares listed in Hong Kong are known as “H-shares”. The two kinds of shares have the same economic interest, but don’t always trade at the same price. In fact, remarkably, the average A-share premium over its equivalent H-share is currently nearly 1.5 times. That is, Mainland investors are paying on average 50 percent more for an identical share that can be purchased in Hong Kong. A time-series of this premium is illustrated by the chart below.
We believe many “clever” investors were buying H-shares in Hong Kong on the prospect that the Southbound Connect quota would be increased. Given the enormous valuation differential between the Mainland and Hong Kong on identical shares, no doubt significant capital would have jumped from the Mainland into the Hong Kong stock market. A-shares would fall and H-shares would rise.
Of course, now with the Chinese Mainland imploding, policymakers will not do anything that may risk A-shares falling any further. Therefore, the prospect of the Southbound Connect quota increasing any time soon has reduced to near zero. Therefore, the trade described above no longer works. We believe the unwinding of these positions have been a primary driver of the sharp recent collapse in Hong Kong stocks.
(We have also noted the sharp movements in the prices of iron ore, coal, copper and oil; and hence are monitoring the prospect of a wider downturn in Chinese aggregate demand. This would have far wider consequences for the global economy, however, it is too early to draw any definitive conclusions at this stage).
Montaka has been positioned well for the recent downturn in Hong Kong. The “downside protection” inherent in our portfolio structure and investment strategy has already started to deliver for our investors.