Hong Kong shares have risen 18 percent since Beijing announced it would allow individual mainland investors to invest without limit in the Hong Kong stock exchange. Despite the apparent arbitrage opportunities, the lure of H-shares for mainland investors is dubious. Even assuming the delays currently blocking the program’s launch are overcome, we doubt that the outflow of mainland capital into Hong Kong will be anything more than a trickle for some time.

The new program, which is available only through Bank of China, will mark the first time individual investors will have access to international capital markets. From the perspective of the average Chinese investor, however, it is not clear what Hong Kong stocks have to offer other than a guaranteed 5 percent annual currency loss for as long as the Hong Kong dollar remains pegged to the US dollar and the renminbi is appreciating.

At first glance, there seems to be an attractive arbitrage play on the 45 Chinese companies listed both on the mainland and in Hong Kong. For these firms, the median price/earnings ratio in late August (when the new investment scheme was announced) was 27 in Hong Kong and 48 on the mainland. The median discount for Hong Kong H-shares was 37 percent.

The play should be obvious – buy cheap H-shares and sell pricey A-shares. Yet we doubt that many mainland investors will make this play. In fact the evidence suggests they have not: in the weeks since the announcement, the median discount for H-shares has risen slightly, to 38 percent. Among dual listed companies, H-shares are trading at 33 times earnings but A-shares are trading at a whopping 53 times earnings.

Two things stand in the way of H/A share arbitrage. First, true arbitrage would involve going long the H-share and short-selling the equivalent A-share. But mainland markets prohibit short-selling so this is impossible. The best one can do is to go long the H-share index and short the A-share index, via exchange-traded funds in Hong Kong.

But can we really be sure the H-share index will rise more rapidly than the A-share index? Alas, we cannot, because the two markets – Hong Kong and Shanghai – still have completely different universes of buyers.

The Hong Kong market is completely open to international capital flows and hence is exposed to the swings of international liquidity. The Shanghai market is almost entirely closed to international capital flows, so prices there are a simple reflection of liquidity in mainland China, which is excessive.

The folly of assuming that because a company’s H-share and A-share prices are different they must therefore converge was exposed in late August after the Bank of China revealed that it owned US$10bn in US sub-prime mortgage securities. The day after the announcement, Bank of China’s “cheap” H-share fell by six percent, while the “expensive” A-share rose. International investors in the Hong Kong market were rightly concerned about the effect of sub-prime exposure on the bank’s future earnings; delirious punters in Shanghai couldn’t have cared less.

The converse, of course, is also true. The A-share market is clearly a bubble and at some point it will pop and prices will collapse. H-shares are not so over-priced and when the crash comes they will not fall so sharply. But that catastrophic convergence of prices might not happen for a year, or two, or even three – depending on how long it takes Beijing to get up the nerve to pop the bubble. In the meantime, however much H-shares rise, A-shares could well rise at least as fast. Mainland investors will prefer to stay at home rather than flock to Hong Kong for the privilege of enduring a currency loss.

Eventually, as Flannery O’Connor wrote, all that rises must converge. But in this case, “eventually” could be quite some time.

Copyright The Financial Times Limited 2018. All rights reserved.

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