深港通 and 扈港通
When trading Chinese stocks through 深港通(Shenzhen-Hongkong Stock Connect) or 扈港通 (Shanghai-Hongkong Stock Connect), we often find companies listed simultaneously on ‘Shanghai and Hong Kong’ or ‘Shenzhen and Hong Kong’ exchanges. Generally, ‘law of one price’ indicates the same product must have the same price applied in any market. However even though the company has the same business structure and performance, the prices of stocks listed on the Shanghai or Shenzhen stocks tend to be overvalued compared to the prices of stocks listed on the Hong Kong Stock Exchange. Why does this happen?
A-Share and H-Share
In order to understand the question, investors need to understand the concept of H-shares and A-shares. H-shares the stocks of Hongkong or Chinese corporates that are listed in Hongkong stock market. Chinese and non-Chinese can trade freely. Meanwhile, A-shares are stocks of Chinese companies that are listed in Chinese market such as Shanghai and Shenzhen stock exchanges, mostly for Chinese investors. Foreign-only stocks are called B-shares. They can be traded by foreigners through the 扈港通 and 深港通 system. However, B-shares are very limited to specific firms.
The A-H premium index is an indicator that needs to be checked in order to determine the relative price level of companies listed in both markets. The AH Premium Index is an indicator of the relative price gap between Shanghai or Shenzhen A shares and Hong Kong H shares for the same company.
Since A-shares are traded in RMB and H-shares are traded in Hong Kong dollar, AH premium index is calculated at the exchange rate of the day in order to compare in the same currency. If the index exceeds 100, it means that A is relatively overvalued, and if it is less than 100, it means that H is overvalued.
In the modern financial market, when a price difference occurs due to a temporary market imbalance for the same target, it is a common phenomenon to close the gap through arbitrage trading. The price gap is resolved because transactions are constantly attempted to obtain profits by buying undervalued objects and selling overvalued objects.
Based on this theory, the prospect that the AH premium will almost disappear from the market was prevailing with system of 扈港通 in November 2014. This is because both Chinese and foreigners in China can buy and sell A and H shares.
However, as the mainland stock market continues to fluctuate, the AH premium index has also been volatile, and the price gap has continued to arise during the fluctuation. In the last decade, the AH premium index has moved between in the range of 90-150.
Why does the price gap between share-A and H occur?
First, capital movement is not completely free due to differences in investment applied to mainland China and Hong Kong markets. In order to be able to trade arbitrage, foreigners must be able to short sell A and buy H shares, but short selling of A-shares is prohibited. In addition, Chinese may have to buy H shares without restrictions through 港股通(Southbound), but individual investors must have 500,000 yuan cash in their stock accounts, and there are limitations in accessibility to investment like such as credit transactions.
Second, the difference in the liquidity environment between the two markets is also causing the price gap. The continued efforts of the Chinese government to open the stock market for foreign capital, such as the implementation of the 扈港通 and 深港通 systems and the expansion of the QFII investment limit, created a favorable environment for the liquidity reinforcement of the mainland stock market. The policy to expand A-share investment opportunities for foreigners is expected to continue.
Third, the difference in the share of major industries between the two markets can be said to be a factor of the price gap. H shares have a high portion of the financial sector at 72%, while A shares have a relatively high share of consumer goods, information technology, and industrial goods that are expected to benefit from the Chinese government's policies. In addition, the willingness to foster mainland Chinese stock markets compared to Hong Kong should be seen as having an impact on price gap.
Finally, degree of perception by investor in both markets such as the direction of the currency rate, and the level of risk-required return can be seen as factors affecting the A-H premium and the gap between the two markets.
According to the Hang Seng Stock Connect AH Premium Index, as of September 2020, companies that were simultaneously listed in China's A-shares and Hong Kong's H-shares are trading at 43% lower levels in Hong Kong's H-shares.
Source: Investopedia
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