On December 17, the Several Provisions on the Interconnection Mechanism for Transactions in the Mainland and Hong Kong Stock Markets (hereinafter referred to as the "Provisions") were released to solicit public opinions. The Provisions clarified the definition of investors who participate in the Shanghai-Shenzhen-Hong Kong Stock Connect, stipulating that "investors enjoy the rights and interests of stocks purchased through the Mainland and Hong Kong stock market trading link mechanism in accordance with the law. Investors in the Shanghai-Shenzhen Stock Connect do not include Mainland investors". The new measure, which will not change much from the increasingly active Shanghai-Shenzhen-Hong Kong Stock Connect, is intended to strengthen supervision of cross-border securities activity. Meanwhile, researchers at ANBOUND believe this new measure is not just about dealing with "fake foreign capital" and the stability of the Mainland's capital market, but also about making up for the oversight of cross-border capital flows and strengthening the control of capital outflows. In the long run, it will have a more lasting impact on both Hong Kong's and the Mainland's capital markets.
The China Securities Regulatory Commission (CSRC)'s amendments to these Provisions are aimed at tightening supervision over "fake foreign capital". The so-called "fake foreign capital" phenomenon refers to the fact that some Mainland investors have opened securities accounts in Hong Kong in recent years and have northbound trading rights to trade A-shares through the Shanghai-Shenzhen Stock Connect. Currently, there are about 1.7 million investors in such deals, but most of them do not actually trade, and only about 40,000 investors are likely to be affected. According to the CSRC, the phenomenon of "fake foreign capital" is not in line with the initial intention of introducing foreign capital through the Shanghai-Shenzhen Stock Connect. 98% of these investors have opened Mainland securities accounts and can directly participate in A-shares trading, so there is a risk of cross-border illegal activities.
The phenomenon of Mainland investors investing and trading A-shares through accounts set up in Hong Kong has actually existed for years. This is mainly due to the low cost of financing, higher leverage, and the possibility of avoiding market regulation. It is reported that due to the high cost of financing and the difficulty of short selling in the Mainland market, many Mainland private equity firms set up institutions in Hong Kong or conduct financing through Hong Kong securities firms, whose cost is only about 1/4 of that of the mainland and the leverage ratio is higher. This has not only raised concerns about high leverage or increased market volatility, but also intensified the phenomenon of "capital concentration" in small- and mid-cap companies.
Meanwhile, some quantitative investment firms enjoy faster transaction speed and have the advantage of T+0 transaction. It has been reported that the Mainland quantitative fund giants that obtained licenses in Hong Kong allocated 5 times of capital in Hong Kong and operated frequently in the A-share market, expanding rapidly in scale. In addition, some Mainland funds take advantage of the fact that Mainland investors like to follow northbound funds to do investment, and disguise themselves as northbound funds in an attempt to influence the share price of A-shares. There are also some institutions using their two accounts in the Mainland and Hong Kong to carry out capital arbitrage and money laundering. These activities are suspected of evading financial regulation and involving policy arbitrage, and have become the main target of Mainland regulators to crack down on financial chaos and prevent "financial risks". It can be said that the implementation of relevant policies will rectify these institutions, making the Mainland capital market more healthy and stable.
The new Provisions give the market a grace period to adjust to comply with the requirements and do not impose past liabilities. In terms of the size and composition of northbound funds, "genuine foreign capital" still accounts for a large proportion. Therefore, the new Provisions may have some short-term impact on A-shares, but will not have a significant negative impact on the Shanghai-Shenzhen-Hong Kong Stock Connect mechanism. According to Haitong Securities research report, about 70% or more of northbound funds are "genuine foreign capital". Some analysts believe that most of the genuine foreign capital will choose foreign banks as clearing banks. As can be seen from the northbound capital of foreign banks, the overall scale of their investment is relatively stable and keeps a trend of continuous growth. Since 2021, foreign banks are still the main component of incremental northbound capital, while the potential influence of mainland investors has increased, but its proportion has decreased. As of December 16, the stock holdings of potential impact funds of Mainland investors are mainly distributed in food and beverage, new energy-related, electronics, medicine, and other industries, among which, Chinese institutions held RMB 17.570 billion, RMB 15.421 billion, RMB 12.181 billion and RMB 11.615 billion respectively, while foreign securities firms held RMB 71.825 billion, RMB 55.636 billion, RMB 39.745 billion and RMB 40.021 billion respectively. There is a large overlap of relevant aspects. Even if "fake foreign capital" is withdrawn from the market, there will not be much fluctuation in the sectors where capital is concentrated. Therefore, from this point of view, whether in terms of incremental or holdings, northbound capital is unlikely to be withdrawn on a large scale due to the implementation of the new Provisions, and the impact lies more in the volatility of individual stocks.
However, with the appreciation of the RMB, foreign capital has been flowing into A-shares at an accelerated pace. The movement of northbound funds from the Shanghai-Shenzhen-Hong Kong Stock Connect also has a guiding influence on mainland investors to a certain extent. These potential risks cannot be ignored. As of December 16, northbound funds showed a state of net buying for 12 consecutive trading days, with a cumulative net inflow of RMB 82.106 billion, exceeding the peak value in December 2019 and setting a new historical record for net buying in a single month. Despite the net outflow on December 17, the latest cumulative net buying amount of RMB 75.543 billion was still higher than that of December 2019. For some individual stocks, the movement of northbound funds will still have an impact on their share prices. If the "herd effect" of Mainland investors is triggered, it is hard to say whether the stability of the A-share market will be affected.
In fact, both A-shares and Hong Kong stocks plunged before the release of the new Provisions are related to the implementation of the new Provisions. The new Provisions signal tightened supervision of cross-border capital flows, which will not only affect the "fake foreign capital", but also the outflow of mainland funds invested in overseas capital markets will be subject to more supervision. These will not only affect Hong Kong stocks, but also affect the share price of some China-concept stocks. In this sense, this measure also implies the strengthening of capital supervision and prevention of capital outflow. On the one hand, the short-term pressure of rapid appreciation of RMB brought by foreign capital inflow can be alleviated by cracking down on "fake foreign capital". On the other hand, through the inspection of "fake foreign capital", the new provisions will also rectify the channel of capital outflow and prevent abnormal capital outflow. It will also be a medium for the Mainland to strengthen RMB trading in the offshore market.
For Hong Kong, the Mainland's enhanced supervision of cross-border capital flows not only involves Chinese institutions in Hong Kong, but also local and foreign financial institutions in Hong Kong, which need to make adjustments to meet the requirements of the Shanghai-Shenzhen-Hong Kong Stock Connect. In this regard, the influence of mainland regulatory policy on the Hong Kong market is also becoming increasingly prominent. This also means that in the process of integration with the Mainland, Hong Kong's capital market will not only gain more benefits, but also be increasingly influenced by Mainland's regulation, with new challenges to the independence and uniqueness of its capital market and financial regulation. In other words, Hong Kong will be actively and passively integrated into the capital cycle of the Mainland in the process of the geopolitical game. This will not only change the landscape of international capital markets, but also have long-term implications for Hong Kong's status as an international financial center.
With the current challenges facing Mainland China's economy, increasing downward pressure, and a growing number of troubled companies, Chinese government departments are expected to attach great importance to the issue of capital outflows. Although the RMB continues to appreciate, government departments are still very strict in regulating foreign exchange channels. Capital outflows by entrepreneurs, including outbound investment and asset transfers, will be strictly regulated, except for the repayment of dollar-denominated debt. Under the trend of strengthening cross-border capital supervision, capital outflow in the capital market will also be subject to more supervision in the future. From this point of view, the tightening of these regulatory policies is justifiable in some ways. However, for the development of China's stock market, as well as the capital markets in the Mainland and Hong Kong as a whole, more attention should be paid to enhancing the system arrangement to avoid the "fallacy of composition".
Final analysis conclusion:
Mainland China's restriction of "fake foreign capital" to participate in the Shanghai-Shenzhen-Hong Kong Stock Connect plays a practical role in preventing capital market speculation and maintaining the health and stability of the A-shares market. That said, it is also more important to strengthen cross-border capital supervision and prevent capital outflow. These moves may have a spillover effect on the capital market of the Mainland and Hong Kong. The relevant parties should indeed pay attention to these potential impacts so as to ensure better policy coordination.
