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China's financial markets: Premium puzzle

via The Economist: Finance and economics on 7/22/10

China's financial markets

Premium puzzle

Enthusiasm for Chinese companies abroad but not at home

Jul 22nd 2010 | Hong Kong

OF THE many oddities surrounding Chinese stockmarkets, the most glaring has long been the premium mainland investors pay for shares listed domestically over what those same shares trade for in Hong Kong. Now the puzzle is why the premium has disappeared (see chart).

The usual explanation for the existence of the premium ran as follows. A closed capital account and a tightly run financial system left Chinese investors with only three places to put their money: property, with its high transaction costs and manic price moves; bank deposits, offering diminutive interest; or shares, with price moves as big as property but lower dealing costs. That paucity of choices drove shares higher than in places with more options.

What, then, has changed? The last time the price of shares simultaneously trading in the mainland and Hong Kong came close to converging was in 2006 when foreign fund managers were flooding into Hong Kong, intoxicated by potential gains from underpriced bank offerings. This time is different. Prices in Shanghai and Shenzhen have fallen by 22% and 15% respectively this year, making the mainland one of the world's worst-performing markets. In Hong Kong prices of shares in the same companies have fallen far less. Outsiders appear more willing to believe China's growth story than the Chinese.

The decline on mainland markets may be because investors are tapped out. Of the $19 billion raised recently by Agricultural Bank of China, more than 60% came from other Chinese state-owned entities. Every big bank is lining up for large capital injections and there have been many other share issues as well. Chinese companies raised $54 billion in equity in the first half of this year (before the AgBank listing) and another $80 billion in debt, according to Dealogic. That's a lot, even for China.

Another possibility regards moves to liberalise the yuan. In a series of decisions—including an announcement on July 19th on various yuan-denominated products banks will be able to trade in Hong Kong—small holes are being punched in the wall separating China's currency and the outside world. Perhaps the gap between shares in Hong Kong and those in the mainland is shrinking because the barriers between the two are falling.

These are just theories, however. Investment bankers are scrambling to work out what is happening to China's markets even as they prepare more companies for flotation. Despite falling prices, the appetite to list remains keen. The pipeline of prospective deals at most of the big banks consists overwhelmingly of Chinese companies, hoping to place their shares at home or in the hands of China-obsessed foreign buyers. Non-Chinese companies are also clamouring to list in Shanghai, a process that could begin early next year. Perhaps the premium has disappeared because foreigners now have fewer appealing choices, too.

Finance and Economics