QDIIs unlikely fools in Hong Kong
market By Mark A DeWeaver
HONG KONG - On April 13, the People's Bank
of China announced the start of the long-awaited
qualified domestic institutional investor (QDII)
program, under which mainland Chinese financial
institutions will be allowed to invest in offshore
securities. The news helped push Hong Kong's Hang
Seng stock-market index close to a record high, as
many expect Hong Kong stocks to be a
big beneficiary of QDII buying.
Despite
all the excitement, however, estimates of
potential QDII inflows into the Hong Kong market
have actually been quite modest. Most call for
US$2 billion to $3 billion this year, barely 0.5%
of Hong Kong's total market capitalization; even
by 2010, the figure is not expected to exceed $10
billion, still less than 2%
of total market
capitalization.
These numbers are also
small compared with the amount of mainland Chinese
money already in the market, probably in
the
$50-billion-to-$100-billion
range, or even to the amount of money raised in
Hong Kong last year by Chinese companies, which
came to $18 billion.
Indeed, it is hard to
see why there should be significant QDII demand
for Hong Kong stocks any time soon. With the Hang
Seng near an all-time high, mainland investors are
likely to see more upside in Shanghai and Shenzhen,
where prices are still low by historical
standards.
Rice porridge and shark's
fin soup Like the qualified foreign
institutional investor (QFII) scheme launched in
2002 - which allows foreign financial institutions
to invest in securities in China - the QDII
program allows cross-border portfolio investment
in the absence of a fully convertible currency.
Licenses to invest a fixed quota of
foreign exchange offshore will be granted to a
relatively small number of banks, insurers, and
fund-management companies. By limiting the number
of licensees and their quota allocations, the
monetary authorities can continue to maintain
tight control over foreign-exchange outflows.
The new regulations specify that qualified
banks and insurers may convert yuan into foreign
currency to purchase fixed-income products,
meaning that their QDII quotas will be invested
primarily in bonds and money-market instruments.
(The banks may raise money from clients, while the
insurers will be limited to investing their own
funds.)
These institutions will only
become buyers of Hong Kong stocks to the extent
that the term "fixed income" is interpreted to
include products such as equity-linked notes that
offer exposure to the stock market combined with a
guaranteed return.
Only fund-management
companies will be allowed to invest directly in
offshore equities, and their clients will be
required to finance subscriptions with foreign
currency. As these funds will be the main QDII
buyers of Hong Kong stocks, the impact of the
scheme on the market will depend largely on the
size of their quotas and the amounts they can
raise.
The main purpose of all this is to
relieve upward pressure on the yuan by increasing
demand for foreign exchange. Interestingly,
however, the Hong Kong market participants and
government officials who originally proposed the
idea back in 2001 had a quite different objective
in mind. They hoped to prop up their local stock
market, which had been struggling in the wake of
the Nasdaq crash in the previous year. As mainland
wags put it, the "rice porridge" money of millions
of Chinese investors was to be used to treat Hong
Kong to some "shark's fin soup".
As things
have turned out, however, most of the shark's fin
soup will instead be enjoyed by holders of
fixed-income securities such as US Treasuries. But
with the Hang Seng close to record territory, all
that rice-porridge money is no longer really
needed anyway.
Fools in the
market Hong Kong's brokers and investment
bankers believe that mainland investors will find
Hong Kong stocks attractive because they are
cheaper than the mainland's A-shares on a
price-earnings ratio (P/E) basis.
Indeed,
Hong Kong is quite a bit cheaper, with an average
trailing P/E of 13 times (for Hang Seng
constituent stocks) compared with an average of 25
times for Shanghai. In addition, for many
companies that have both H- and A-shares listed,
the former are at discounts, suggesting
opportunities for profitable arbitrage. (H-shares
are the Hong-Kong listed equities of
mainland-registered companies, while the
yuan-denominated A-shares are listed on the
domestic exchanges.)
But that's not
necessarily how the mainland investors see it. In
a recent note to clients, one Chinese broker has
argued that Hong Kong, now in the fourth year of a
bull market, is unlikely to outperform the
A-shares, which are just recovering from a
four-year bear market.
This lack of
enthusiasm for Hong Kong stocks is easy to
understand. Since June 2001, the Shanghai
composite index has fallen almost 30%, while the
Hang Seng Index has risen more than 25% and the
Hang Seng China Enterprises Index, which tracks
the H-shares, is up more than times.
The
problem with arguments based on relative valuation
is that, as an old maxim says, "no stock is
overvalued as long as it will continue to go up".
Mainland P/E ratios may be high compared with Hong
Kong, but they are still at only about half their
2001 levels. As long as the Chinese markets
continue to be driven primarily by liquidity
rather than "fundamentals", there is no obvious
reason those old record multiples cannot be
revisited.
Another maxim has it that you
can't make money in stocks without a "greater
fool" to sell to. Mainland institutions might
reasonably think of the domestic small investor as
a good candidate for this role. But as QDII buyers
of Hong Kong stocks, they run the risk of buying
close to the top, thus being put in this
unenviable position themselves. This danger makes
it unlikely that they will be as eager to invest
in Hong Kong as the market seems to be expecting.
Mark A DeWeaver, PhD, worked as
a research analyst in Shenzhen from 1991-95, first
for W I Carr and later for Peregrine Brokerage. He
manages Quantrarian Asia Hedge, a fund that
invests in Asian equities (on the web at
www.quantrarian.com) and can be reached at
deweaver@quantrarian.com.
(Copyright 2006
Mark A DeWeaver. Used
by permission.)
