Wednesday, 14 October 2009
The return of the H-share premium
It is exactly three years since H-shares in Hong Kong last traded at a premium to their A-share counterparts in China. Since then, they have traded at a discount, ranging as high as 68 per cent at the start of last year to as low as 13 per cent today. Looking ahead, a downturn in the liquidity environment in China relative to a continued build up in excess liquidity in Hong Kong imply that the premium of H-shares over their A-share counterparts is set to return.
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The return of the H-share premium
Two factors will drive change in relative value of H-shares over their A-share counterparts
By CLIVE MCDONNELL
14 October 2009
It is exactly three years since H-shares in Hong Kong last traded at a premium to their A-share counterparts in China. Since then, they have traded at a discount, ranging as high as 68 per cent at the start of last year to as low as 13 per cent today. Looking ahead, a downturn in the liquidity environment in China relative to a continued build up in excess liquidity in Hong Kong imply that the premium of H-shares over their A-share counterparts is set to return.
Two factors will drive the change in the relative value of H-shares over their A-share counterparts: an influx of capital into Hong Kong as China begins to realise its ambition to internationalise its currency and an increase in inflation in China, which will result in policy makers adopting a less-accommodative monetary policy stance.
The long march to internationalisation of the Chinese yuan can be traced back to 2003 when Hong Kong banks were allowed to accept yuan deposits. This policy shift culminated in China’s decision this year to allow direct yuan trade settlement between mainland Chinese companies in selected cities and companies in Hong Kong.
While there is a clear need for China to resume its 2005-2008 policy of allowing the currency to appreciate, our China economics team believes that there is no appetite among policymakers to put exporters under more pressure than they are currently experiencing. As such, we are not forecasting a change in the spot US dollar (USD)/yuan exchange rate during next year.
Despite our own forecast, there is already evidence that investors are looking beyond policymakers’ desire to protect exporters in the short term. The non-deliverable forward (NDF) market has recently started to discount a resumption of exchange rate appreciation. The combination of an influx of capital into Hong Kong as investors buy yuan denominated bonds to benefit from future exchange rate appreciation and Hong Kong’s role as a settlement centre for yuan trade will result in a further boost to money supply in Hong Kong.
There is a clear historic relationship between Hong Kong money supply, the USD/yuan exchange rate and H-shares. Our analysis highlights a dramatic acceleration in money supply in 2005 as excess liquidity built up, coinciding with the start of yuan appreciation against the USD. This in turn was correlated with the surge in the H-share index.
Given the historic relationship between the H-share market and money-supply growth, we forecast the index to reach 15,000 next year, a 25 per cent gain from current levels.
Our forecast for a 25 per cent gain in H-shares from current levels would ordinarily be mirrored at the minimum in a similar performance of A-shares in China. However, we do not believe that the domestic A-share market will perform as well as the offshore market next year. This view is driven by our forecast of a deterioration in the liquidity environment in China versus an improvement in Hong Kong. This forecast is at the heart of our view that the H-share index could start to trade at a premium to A-shares next year.
Economic growth in China next year will be faster than this year at 9.5 per cent; however, the positive effect of the surge in investment and government spending has already been discounted by the market. The risk next year is for credit growth to actually decline as policymakers turn their attention to the narrowing of the output gap, which - based on our forecasts - will close by Q2 next year.
Higher interest rates
An estimated 30 per cent increase in credit growth this year to nine trillion yuan (S$1.8 trillion) in combination with the four trillion yuan fiscal stimulus announced in Q4 last year was an appropriate response given the scale of the global crisis at that time. With the economy now firmly in recovery mode, there is no need to repeat that stimulus next year. The positive effect of the stimulus will continue to flow through to corporate earnings. However, investors will change their focus to the next policy shift - higher interest rates. While this is likely to weigh on domestic asset markets, no such restraint is likely in Hong Kong.
The narrowing of the output gap in combination with the surge in new lending this year is likely to increase inflationary pressures next year. Policymakers are acutely aware of this risk and are likely to switch their appropriately lose monetary policy to a less accommodative stance beginning in Q4 this year. Higher reserve requirements will be the first layer of adjustment, with higher interest rates to follow.
It is worthwhile contrasting the forecast, less accommodative monetary policy in China, from Q4 this year, with the ultra-loose policy in Hong Kong. The Hong Kong dollar currency board arrangement implies that interest rates are set by the Fed, as opposed to the Hong Kong Monetary Authority (HKMA). Our economics team forecast the Fed will not raise interest rates until 2012, implying that Hong Kong will have a pro-cyclical monetary policy.
In contrast to prior cycles where investors focused mostly on local beneficiaries of this asset price bubble, Hong Kong’s status as the offshore finance centre for yuan business implies that there will be a increased focus on China-related shares. We are drawn to the conclusion that the effect of this will be to push H-shares to trade at a premium to their A-listed counterparts.
Domestic investors in China are correct to fret over the impact of higher interest rates on lending growth and non-performing loans. However, just as excess liquidity in China between 2006-08 resulted in A-shares trading at a substantial premium over their H-listed counterparts, the build up in excess liquidity in Hong Kong next year will push H-shares to trade at a premium over their A-share counterparts.
The writer is head of equity strategy, BNP Paribas Securities
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