Hong Kong's biggest arbitrage trade gets a boost from China

[HONG KONG] Cheap Hong Kong equities are suddenly back in vogue with Chinese investors.

As tightening capital controls turn the city's stock market into one of the few Beijing-approved destinations for offshore investment, mainland traders are piling into shares that have long been priced at much lower levels than their counterparts in China. Average daily inflows through Hong Kong's exchange links swelled to the highest since September this month, while the city's Hang Seng China Enterprises Index is the best performer among major world equity gauges this week.

The influx of mainland money has helped narrow valuation gaps between the markets, which persisted for more than two years despite growing cross-border connectivity. Even so, dual-listed stocks remain about 33 per cent cheaper on average in Hong Kong. Pictet Asset Management and East Capital say the city's re-rating has further to go.

"We expect the trend to continue for a while longer as valuations in Hong Kong are attractive," said Pauline Dan, the Hong Kong-based head of Greater China equities at Pictet Asset Management, which oversees about US$462 billion worldwide. "The market is a good choice for Chinese investors who seek exposure to overseas assets but face challenges bringing money out of the country."

Investors bought a net 11.4 billion yuan (S$2.35 billion) of Hong Kong equities through the Shanghai and Shenzhen exchange links during the five full trading days so far in February, taking this year's total inflows to 34.1 billion yuan. As a high-profile part of President Xi Jinping's pledge to integrate China's financial markets with the world, the links have been left out of a sweeping government campaign to clamp down on capital outflows and prop up the yuan.

While mainland investors using the stock connect program have to be repaid in yuan when they sell Hong Kong shares, they are shielded from any depreciation in the Chinese currency while their money is on the other side of the border. Inflows into the city have propelled the Hang Seng China index of so-called H shares to a 5 per cent rally since Feb 3, the second-best performance among 95 equity gauges tracked by Bloomberg after the Jamaica Stock Exchange Market Index. The H-share measure rose 0.8 per cent at 9:45am in Hong Kong.

"Offshore Chinese markets offer, in the short term, a better investment alternative for mainland investors," said Francois Perrin, a money manager at East Capital Asia Ltd in Hong Kong. He added that dual-listed shares trading at a discount in the city are among buyers' primary targets.

Not everyone is so bullish. Frank Lee, acting chief investment officer for North Asia at DBS Bank (HK) Ltd, sees several risks to the market. He says rising interest rates in China could lure funds back from Hong Kong, while uncertainty over US President Donald Trump's economic agenda and elections in France could prompt global investors to dump equities.

What's more, Hong Kong-listed stocks are no longer trading at rock-bottom prices. The Hang Seng China index exceeded the value of its constituents' net assets for the first time in four months this week, after trading at a discount of as much as 26 per cent last year, according to data compiled by Bloomberg.

"The H-share market has been a surprise on the upside," said Khiem Do, the Hong Kong-based head of Asian multi-asset strategy at Baring Asset Management. "But I wonder if it is perhaps a little bit too complacent."

Bulls take comfort from the fact that the Hong Kong market hasn't come anywhere close to closing the gap with mainland valuations. The Shanghai Composite Index trades for 1.8 times book value while its counterpart in Shenzhen has a ratio of 3.6, a 255 per cent premium over the Hang Seng China gauge.

"Funds may be repositioning their allocations to add more low-valuation names," said Ethan Wang, the head of investment strategy for China wealth management at Standard Chartered Bank. "H shares are certainly attractive."

BLOOMBERG