The fun and games are about to begin. Photo: Reuters/Bobby Yip
The fun and games are about to begin. Photo: Reuters/Bobby Yip

The long-awaited Shenzhen-Hong Kong Stock Connect finally kicks off on Monday. For mainland Chinese investors, the promise of low valuations and high dividend yields offers an enticing prospect – one that may well occasion distress in Beijing given the government’s existing anxieties about money outflows and yuan depreciation. The draw being flaunted for foreign investors is Shenzhen’s ostensibly sexy tech sector – but these are stocks fraught with market and regulatory risk.

The Shenzhen stock exchange is the world’s eighth largest and worth US$3 trillion. Hong Kong’s (US$3.25 trillion) is the sixth largest. The new connect is the second stock-trading link between mainland China and Hong Kong and goes further than the Shanghai-Hong Kong Stock Connect, which launched two years ago: this time China has decided to unlock access to tech stocks under the Small or Mid Cap Innovation Index that have a market cap of 6 billion yuan or above. In all, 880 stocks listed in Shenzhen will become eligible for trading.

Simultaneously, 417 stocks listed in Hong Kong that were previously off limits to mainland investors – including small cap stocks with market cap of at least HK$5 billion – will suddenly be accessible to them.

The big unknown is whether foreign investors will have the guts to buy Shenzhen tech stocks – which are seen as expensive and volatile, even while having large upside potential.

“Though the growth potential is attractive to foreign investors, they may not jump into the Shenzhen market once the trading link is kicked off,” says Fielding Chen, a China economist from Bloomberg, “because the valuations of these stocks are generally too high.” A fifth of Shenzhen’s stocks are in so-called “new economy” tech companies – but tech companies are prone to fluctuating fortunes and indeed failure.

Not only are these stocks more volatile compared to those on the Shanghai market, which has many state-owned enterprises with greater capitalization, but Shenzhen’s stocks overall have been trading at a high average price-to-earnings ratio of 42, compared with 15 for Shanghai. A high turnover rate of between 277% and 479% indicates fervent trading. Chen predicts that foreign investors will approach with caution, perhaps picking up lower-valued shares that show good growth potential in the medium to long term.

Mainland investors likely to flock into Hong Kong small caps stocks

Analysts are much more optimistic about the demand for Hong Kong small caps.

Compared to Shenzhen’s, Hong Kong’s small caps generally have lower valuations and higher dividend yields, which is what mainland “mom and pop” investors tend to look for.

Analysts from BOC International expect a net inflow of 250 billion yuan in trading volume via the southbound trading link by next year – which they anticipate will lead to a re-rating of the Hong Kong market.

Against the backdrop of potential yuan depreciation during a strong US dollar cycle, mainland investors may well find themselves glad to have a new channel via which to hedge their assets.

Read: Hong Kong-Shenzhen stock trade link to launch on December 5

Since early October, capital has retreated from the mainland housing market due to the government’s crackdown on speculation and it is likely to find its way to the stock connect.

Further restrictions on the purchase of certain overseas savings-type insurance products through UnionPay in late October may have the same result.

Chen is quick, however, to point out that as Hong Kong’s market fundamentals are largely in line with mainland China’s, any fluctuations in the latter economy will affect Hong Kong too. Therefore, investing in Hong Kong stocks may not be a failsafe way of fleeing yuan depreciation.

The Shenzhen-Hong Kong Stock Connect represents another small step in China’s opening up to more foreign money. Concern about yuan outflows has long exercised the Beijing government and that is likely to continue as investors look south. Certainly, China’s clearing house will require a lot of Hong Kong dollars when it comes to net settlements at the end of a trading day – to begin with at least.