The Battle of the Exchanges Takes Off Between China and Hong Kong

Shortly before Charles Li boarded a plane to Beijing, the head of Hong Kong’s stock exchange admitted that there had been some “disagreements” over the future of Stock Connect, the trading link between Hong Kong and mainland China’s equity markets.

At the heart of the dispute was a weekend announcement by the Shanghai and Shenzhen stock exchanges that domestic retail investors would be barred from buying companies that offer dual-class shares through Stock Connect, hitting shares in smartphone-maker Xiaomi only a week after they started trading in Hong Kong. The announcement also barred investors from buying “stapled” securities — which bind together two or more types of shares in one company — and foreign companies listed in Hong Kong.

The announcement … has to be seen in the light of the battle between regional exchanges.

Philippe Espinasse, former head of equity capital markets at Nomura

The move was aimed at protecting less sophisticated investors from the complexities of such shares, the exchanges said. Governance activists have long warned that companies with dual-class shares give greater voting rights to founders at the expense of ordinary investors.

But some market experts say the claim by the mainland exchanges that they were protecting investors is a fig leaf, and that the move might be a way to gain a competitive advantage while limiting the amount of money leaving the country.

The danger for Hong Kong — which prompted Li to jump on a plane to meet Chinese regulators and exchange officials — is that the measures, if implemented long term, could threaten its status as Asia’s international financial center.

“The announcement by the bourses of Shanghai and Shenzhen clearly has to be seen in the light of the battle between regional exchanges … to secure listings of Chinese technology companies,” says Philippe Espinasse, a former head of equity capital markets at Nomura. “It is likely to have an impact on the after-market valuations of these businesses.”

The divergence between the exchanges comes as China and Hong Kong battle to attract “new economy” businesses and lure back Chinese technology groups, such as Alibaba, Baidu and JD.com, to list on their respective trading venues. A number of Chinese tech unicorns have opted to list in New York, which, unlike China, allows for dual-class shares and other exotic structures and is where Alibaba broke the record for the largest flotation, raising $ 25 billion in 2014.

In an attempt to compete, Hong Kong this year made the controversial decision to allow companies to list with dual-class shares, a form of security that is particularly popular among technology groups and entrepreneurial companies where founders want to retain a larger degree of influence.

Soon after, the Chinese regulator said it would allow certain companies, including Chinese technology groups that floated overseas with dual-class shares, to list on mainland exchanges by issuing Chinese depositary receipts (CDRs), an equity-like security.

However, if Chinese investors could access dual-class companies through Stock Connect, it would undermine the need for the company to issue CDRs on the mainland, according to bankers and investors. Xiaomi had aimed to offer CDRs, but shelved plans last month without giving a reason for the decision.

“Having Stock Connect renders CDRs meaningless, because if investors could buy Xiaomi southbound through Stock Connect, then what is the point in buying a CDR?” says one banker close to Xiaomi. “The CSRC [the Chinese regulator] is doing a lot of work on getting CDRs up and running. You either have the CDR or you have Stock Connect.”

There is some speculation that the move by the Chinese exchanges is a way to prevent money from leaving the mainland, at a time when the domestic stock market is selling off. Trade tension between the U.S. and China has weighed on the Shanghai Composite index, which this month entered bear market territory after falling 20 percent from its peak in January.

“The obvious market impact is to distort demand for these Chinese stocks in HK and keep the onshore and offshore markets segregated,” says Chi Lo, senior economist for Greater China at BNP Paribas Asset Management. “But from a policy perspective, Beijing sees it as a necessary step to prevent capital outflows and curb onshore market volatility.”

However, other investors said the competitive tension was a more significant factor.

“I am not as convinced as some that they want to limit money leaving the country … but it does raise a point about Hong Kong versus Shanghai and Shenzhen,” says Mark Tinker, head of equities in Asia for Axa Investment Managers.

“The CDR plan has been put on hold, but obviously if Hong Kong Exchange can list such shares and they then sit on the Stock Connect, then there is no reason for a CDR market. I suspect this may also be a factor in preventing the inclusion,” Tinker says.

Although the development might have a limited impact in the short term — Xiaomi is the only company with dual-class shares listed in Hong Kong — analysts see the smartphone-maker as setting a blueprint and expect a string of businesses to follow suit.

While the ban hinders Chinese domestic investors, foreign investors are still able to invest in companies with dual-class and stapled shares, as well as foreign companies listed in Hong Kong.

“The announcements definitely give you a sense of competition between the exchanges,” says Eugenie Shen, a managing director at Asifma, a Hong Kong–based group representing market participants. “But for foreign investors, who buy shares in China through northbound Stock Connect, this doesn’t impact them.”

However, she added that the move to bar access to foreign companies may hurt the “competitiveness of Hong Kong” in attracting overseas businesses to list.

Although the measures published at the weekend caught investors off guard, analysts and bankers say the announcement left the door open for future changes — causing uncertainty for businesses seeking to raise funds through the stock market.

For Li, the short-haul flight to Beijing on Monday could be one of many trips to the mainland to thrash out the future of the Hong Kong exchange as it seeks to compete with China and the U.S.