Hong Kong Discount to Chinese Stocks May Disappear

By Lu Wang

Jan. 11 (Bloomberg) -- China’s approval for short sales and stock index futures paves the way for foreign investors to bet on a convergence in valuations between Shanghai and Hong Kong.

The China Securities Regulatory Commission cleared the overhaul of trading laws on Jan. 8 that will also permit buying equities with brokerage loans. The rules apply to Chinese citizens and the 94 international institutions authorized for mainland trading by the government.

Allowing investors to profit from share declines will make trading more efficient in China and may eventually reduce the valuation gap with Hong Kong, where an index of mainland-based companies is priced at a 38 percent discount, according to ING Groep NV. China’s benchmark Shanghai Composite Index is valued at about 34 times earnings, second behind Taiwan’s Taiex Index as the most expensive in Asia, data compiled by Bloomberg show.

“It’ll make it easier for market players to conduct the arbitrage,” said Philip Schwartz, who manages $1.3 billion of international equities at ING Investment Management in New York. “It’s going to be more from Shanghai side down because these stocks are traditionally more expensive. The arbitrage may work, but it may take a very, very long time.”

Amsterdam-based ING, the largest Dutch financial services company, was approved to invest in mainland local-currency stocks and bonds under the qualified foreign institutional investor, or QFII, program in 2003. Schwartz said he doesn’t short sell a stock or do arbitrage.

Short Sales

In a short sale, an investor borrows an asset and sells it, hoping to profit from a decline by repurchasing it later at a lower price. An investor arbitraging China might buy shares in Hong Kong and sell short the same company trading on the mainland.

“I would do the trade immediately if I could,” said Michael Cheah, who manages $2 billion at SunAmerica Asset Management in Jersey City, New Jersey. “This is a natural development in the Chinese stock market. The real test will be when we have a sell-off, will they suspend shorting?”

The Shanghai Composite climbed 1.3 percent to 3,239.02 as of 10:57 a.m. local time, after rising as much as 3.5 percent, its biggest gain in three months. The CSI 300 Index, which tracks the 300 biggest stocks traded in Shanghai and Shenzhen, added 0.7 percent, after jumping as much as 3.3 percent earlier. The Hang Seng China Enterprises Index, made of shares of mainland companies traded in Hong Kong, increased 1.7 percent.

Sinopec, PetroChina Valuations

China Petroleum & Chemical Corp.’s shares in Hong Kong are valued at 17.3 times reported earnings, less than half the 38.2 multiple for the stock in Shanghai. For PetroChina Co., the nation’s biggest oil producer and the world’s largest company by market value, the shares in Hong Kong trade at a 34 percent discount to Shanghai, based on Jan. 8 prices prior to the government’s announcement.

Pakistan imposed curbs that kept stocks from falling below their closing prices on Aug. 27, 2008, for almost four months, shielding investors from a record sell-off. The price curbs stalled most trading, leading JPMorgan Chase & Co., the biggest U.S. bank by assets, to end its stock brokerage services there in November 2008.

China, whose economy grew 8.9 percent in the third quarter of 2009, currently bars overseas investors from trading yuan- denominated stocks and bonds on the mainland except through the QFII program.

Kenneth Fisher, who oversees $35 billion as chairman of Woodside, California-based Fisher Investments Inc., said that the short selling and futures investments won’t necessarily lower prices.

‘Increased Arbitrage Trend’

“We have seen in many places an increased arbitrage trend that is not consistent with one direction or the other,” said Fisher, who has $808 million of investments in China through Hong Kong shares and American depositary receipts. “What is consistent is that it creates more liquidity.”

Index futures may help ease fluctuations in the world’s third-largest equity market by value after the Shanghai Composite doubled in 2007, then slumped 65 percent in 2008 before rebounding 80 percent last year. Until now, Chinese investors could only profit from gains in equities.

China’s stock market will become “more rational” with the introduction of stock index futures, margin trading and short selling, Deutsche Bank AG said in a report yesterday.

More Hedge Funds

The relaxation may spur the creation of more hedge funds in Asia, according to Ken Heinz, the president of Hedge Fund Research Inc., based in Chicago. Hedge funds are mostly private pools of capital whose managers participate substantially in the profits from speculating on whether the price of assets rise or fall.

“It means we have the ability to hedge more positions to the market to reduce risk,” said Chris Ruffle, China co- chairman of Edinburgh-based Martin Currie Investment Management Ltd., which manages $19 billion, including shares of Chinese companies. “It also offers a certain flexibility, and if you want to increase or reduce weightings, you can do it much more rapidly than buying individual stocks.”

Brazil approved short selling and margin accounts in 1996, according to the press department for BM&FBovespa, operator the country’s biggest exchange. The number of hedge funds in Brazil more than doubled since 2001 to 4,400 last year, exchange data show.

More Liquidity, Efficiency

“It without a doubt created more liquidity and more efficiency,” said Marcelo Mesquita, a partner at Rio de Janeiro-based Leblon Equities Gestao de Recursos Ltda. and former head of Brazil equities strategy for UBS AG. “It helped organize the market. When the market is organized, it works faster, prices fall and it becomes more efficient.”

The first stock index contracts, based on China’s CSI 300, may begin trading after the Communist party’s annual congress in March, an official with knowledge of the matter said.

Morgan Stanley advised investors to buy shares of brokerages and the index’s largest companies by weighting, saying that the new rules may boost trading volumes by 50 percent “in the long term.”

Foreign investors should “focus” on China Merchants Bank Co. and Bank of Communications Co., among the largest stocks on the CSI 300 whose Hong Kong-traded shares show “high positive correlation” with their mainland counterparts, Morgan Stanley analysts Jerry Lou and Allen Gui advised in a note today.

The rules will increase trading and brokerages will benefit, according to James O’Leary, who helps manage $3 billion at Navellier & Associates in New York. Still, O’Leary said he prefers investing in Chinese companies through Hong Kong and the U.S.

“It’s still the People’s Republic of China,” he said. “If they don’t like what’s going on there, they can just stop immediately without any warning.”

To contact the reporter on this story: Lu Wang in New York at lwang8@bloomberg.net