11 Oct 2017

HKEX releases Research Report on the Primary Equity Connect initiative

Posted by Editor

Introduction

The Primary Equity Connect (“PEC”) initiative is a key element of The Hong Kong Exchanges and Clearing Limited’s (“HKEX”) Strategic Plan 2016 – 2018, specifically to complete Mainland-Hong Kong Mutual Market connectivity of the equity market segment. The PEC aims to expand cross-border accessibility to the primary equity markets in both the Mainland and Hong Kong for mainland and global investors. This will be achieved by allowing Mainland investors to subscribe for Initial Public Offerings (“IPOs”) in the Hong Kong market via the PEC (Southbound) and global investors in Hong Kong to subscribe for IPOs in the Mainland market via the PEC (Northbound). It is believed that this initiative will be of mutual benefit to each market in view of the limited “internationalisation” development of both markets. Industry players have expressed interest in the PEC, in the belief that the initiative will improve market liquidity, expand investor base and attract sizable global IPOs. However, concerns have been raised regarding the PEC’s potential negative impact on both markets, as well as regulatory and operational complications relating to the implementation of the PEC. In response to such concerns, HKEX has released a research report seeking to elaborate and clarify the details of the PEC, to address the concerns, and to enhance public confidence and support for the initiative.

Background

HKEX has identified deficiencies currently faced by the Mainland and Hong Kong markets:

(a) A Mutual Market without primary market connectivity; and

(b) Developmental bottlenecks in Mainland and Hong Kong stock markets.

The table below summarises the deficiencies as presented by the HKEX:

Deficiency

Details
(a) a Mutual Market without primary market connectivity
  • Currently, equity trading through the Stock Connect scheme (“Stock Connect”) is limited to secondary equity market trading, and investors on either side of the border are barred from the primary equity market on the other side.

 

  • As such, investors on either side are unable to utilise the investment potential offered by initial public offers of newly listed companies on the other side.
  • The lack of primary market connectivity in the Mainland-Hong Kong mutual market may be detrimental to investor interests in the secondary market and lead to market unfairness.

 

  • Recent spin-off of BOCOM International Holdings Company Limited (“BOCOM International”) by Bank of Communications Co., Ltd (“BOCOM Bank”) is a prime example.
  • A-share shareholders of BOCOM Bank were not provided the same assured entitlement to new shares in BOCOM International as H-Shares shareholders were entitled, due to existing legal and policy constraints.

 
(b) Developmental bottlenecks in Mainland and Hong Kong stock markets Mainland market:

  • The Mainland market has had limited success with internationalisation.

 

  • Before the launch of Stock Connect, Qualified Foreign Institutional Investors (“QFIIs”) and Renminbi Qualified Foreign Institutional Investors (“RQFIIs”) were the only foreign investors eligible to invest in the Mainland stock market.
  • As at the end of 2016, there were only 1,088 QFII accounts and 1,078 RQFII accounts with the China Securities Depository & Clearing Co., Ltd, representing less than 1% by number of accounts in total1.

 

  • As at the end of March 2017, the total investment of QFIIs in the Mainland stock market totalled RMB114,440 million, representing less than 0.3% of the total negotiable market capitalisation on both the Shanghai Stock Exchange (“SSE”) and Shenzhen Stock Exchange (“SZSE”)2.
  • No foreign companies are as yet allowed to list in the Mainland domestic stock market.

 

  • The market structure of the Mainland stock market is specifically designed to cater to the peculiar needs of the Mainland market, which may be at odds with international practices.

Hong Kong market:

  • The Hong Kong market is highly internationalised in terms of investor participation, but is significantly less internationalised in terms of listed issuers.

 

  • During the period of 2008 – 2017Q1, merely 8% of newly listed companies were of foreign origins (excluding Hong Kong and Mainland China), representing 20% of total IPO funds raised.  In contrast, 47% of newly listed companies were Mainland private enterprises, and H-share companies raised 48% of total IPO funds, in the same period3.

In light of the above deficiencies, HKEX proposes that the mutual market connectivity model with access to the primary equity market via PEC, supplemented by access to the secondary stock market via Stock Connect, will sufficiently remedy those deficiencies. The PEC will also provide various benefits to the Stock markets on both sides of the border, and contribute to China’s wider economic strategy of attaining a balanced economy, opening up the financial market, and fully realising RMB capital account convertibility.

Implications

The PEC’s potential benefits to both the Mainland and Hong Kong markets are detailed in the table below:

Potential Benefits

Mainland Market

Hong Kong Market
(a) The PEC (Southbound) will open up an additional global asset allocation channel for Mainland investors, allowing them to subscribe to new shares of international companies to be listed in Hong Kong.  As such, the overseas portfolio investment of Mainland capital will be enhanced. Given the significant size of Mainland domestic savings and abundance of business opportunities in China, and that the PEC (Southbound) will allow Mainland investors to subscribe to IPOs in Hong Kong, this should attract international companies to list in Hong Kong.
(b) The PEC (Northbound) will provide the Mainland with more opportunities for developing the international investor base in the domestic market. Increased market liquidity in both primary and secondary market due to increased international listings and Mainland investor participation.
(c) The PEC under the Mainland-Hong Kong Mutual Market model allows foreign issuers to abide by the internationalised rules and standards of the Hong Kong stock market, instead of needing to conform to the regulatory framework of the Mainland stock market. More business opportunities to market intermediaries.
(d) The PEC will provide more listing opportunities to Mainland enterprises, specifically to Mainland enterprises waiting in the Mainland IPO queue. Listing in Hong Kong is also a viable alternative for Mainland enterprises targeting a Mainland investor base, by virtue of the PEC (Southbound).
(e) The PEC (Southbound) allows Mainland investors to gain international experience of IPO shares subscription and price movements upon listing, thus helping to nurture the Mainland investor base.
(f) The closed-loop system of the PEC will alleviate risks of capital outflow
(g) Accelerate RMB convertibility

However, there are legitimate concerns in connection to the implementation of the PEC. Sound market regulations for the PEC will have to be established to ensure a fair environment for investors, and to provide adequate investor protection and risk control. This may include eligibility criteria for issuers and investors, and obligations and liabilities of interested parties such as exchanges, market regulators, intermediaries, issuers and investors on both sides of the Mutual Market. Additional disclosure requirements may also need to be imposed for both IPOs under PEC (Southbound) targeting Mainland investors, and IPOs under PEC (Northbound) offered to local and global investors in Hong Kong. A coherent and well-constructed regulatory framework will ensure that regulatory incidents relating to issuers under PEC which impact investors’ interests could be minimised and resolved.

Operational concerns, such as those relating to IPO procedures and general market practices were raised:

(a) whether cross-border retail investors will be allowed to subscribe for PEC shares, or will PEC shares only be open to cross-border institutional investors;

(b) how PEC shares will be allotted to cross-border investors;

(c) whether there will be a separate subscription pool for cross-border subscription, or a combined pool with domestic market subscription;

(d) whether cross-border subscription be subject to different market rules or follow the IPO home market rules;

(e) whether cross-border investors be served by intermediaries in the IPO home market or in the investor’s market; and

(f) whether intermediaries serving cross-border investors be subject to different regulatory requirements, such as Know-Your-Client rules and placement guidelines.

For example, with regards to (a), if the PEC allows retail investors in the Mainland to subscribe for IPO shares, it may entail additional regulatory requirements for the listing company, as this will be deemed as a mainland public offering. This will foreseeably lead to increased time and costs for the listing company. Conversely, if the PEC only allows institutional investors in the Mainland to subscribe for IPO shares, the listing will be exempt from those regulatory requirements. Such operational uncertainties must be properly remedied to preserve market fairness and integrity.

It is anticipated that with considerable effort, a suitable model design catering to the best interests of the Mainland-Hong Kong Mutual Market will be able to effectively address the regulatory and operational concerns, and the PEC will be a successful endeavour benefitting both the Mainland and Hong Kong markets.

This newsletter is for information purposes only. Its content does not constitute legal advice, and should not be treated as such. Stevenson, Wong & Co. will not be liable to you in respect of any special, indirect or consequential loss or damage.

Please contact our Eric Lui or Rodney Teoh for any enquiries or further information.

1 Refer to HKEX Research Report “Primary Equity Connect – A Breakthrough Opportunity for Mainland-Hong Kong Mutual Market Connectivity and RMB Internationalisation” pp 7; and CSDC Monthly Statistics, CSDC website, December 2016
2 Refer to HKEX Research Report “Primary Equity Connect – A Breakthrough Opportunity for Mainland-Hong Kong Mutual Market Connectivity and RMB Internationalisation” pp 7; and Southwest Securities research report on QFII 2017Q1 shareholding status, 1 May 2017
3 Refer to HKEX Research Report “Primary Equity Connect – A Breakthrough Opportunity for Mainland-Hong Kong Mutual Market Connectivity and RMB Internationalisation” pp 10 – 11 and Figure 7