In November 2014, the Shanghai-Hong Kong Stock Connect (the “Shanghai Train”), a pilot program for establishing mutual stock market access between mainland China1 and Hong Kong was officially launched. The new cross-border investment channel establishes mutual stock market access between Hong Kong and mainland China, allowing Hong Kong and international investors to invest directly in designated securities listed on the Shanghai Stock Exchange, and investors from mainland China to invest directly in designated securities listed on the Hong Kong Exchanges and Clearing Limited (“HKEx”).2
Following the launch of the Shanghai Train, a second connect, the Shenzhen-Hong Kong Stock Connect (the “Shenzhen Train”) was introduced. Although expected to commence operations in the summer months of 2015, following the recent stock market turbulence, the Shenzhen Train is likely to be delayed3 and details regarding its launch have yet to be released. Despite volatile trading conditions, investors eager for a further boost of trading have been calling for a third connect, in the form of a China-Hong Kong commodities link.
Part 1 and Part 2 of this e-update series have discussed key features of the Shanghai Train and Shenzhen Train, respectively. Part 3 discusses the unique nature, foreseeable advantages, as well as practical concerns and constraints, regarding the proposed commodities link.
Functions of the Commodities Connect
The HKEx is the driving force behind a commodities trade link, which it envisages will provide traders in mainland China with access to international benchmark commodity futures while offering mainland contracts to overseas traders.4 China is both the largest producer and largest consumer of aluminum and iron ore and the largest consumer of most other commodities, such as coal, copper and nickel;5 however, the mainland’s commodity markets are currently inaccessible to international investors due to capital controls and restrictions on overseas exchanges running physical warehouses in the mainland.6 The HKEx is well placed to connect China’s commodities exchange with the international market, having completed the acquisition of the London Metal Exchange (the “LME”) for £1.39 billion7 (US$2.148 in December 20129).
The scheme would be similar to the Shanghai Train, connecting the HKEx to one of China’s state-owned commodity houses, three of which are located in Shanghai, Dalian and Zhengzhou.10 The HKEx would work with the mainland’s commodities exchanges and warehouse operators on the physical delivery of metal contracts to mainland investors when trading at the HKEx or the LME. The LME intends to focus on increasing liquidity, improving pricing and transparency and plans to launch new products in Hong Kong and London while reforming its pricing and warehouse system.11
Commodities vs. Stock
While supporters of the commodities connect are pointing to the success of the Shanghai Train as evidence of the feasibility of a mutual-market-access model, others have noted the complexity in linking the commodity markets in Hong Kong and the mainland. Unlike the trading of stocks, which requires cash settlement only, metals or commodities trading are settled with physical delivery or cash, making physical delivery central to the development of spot commodity products.12 The complex nature of commodities trading relative to equities also presents a number of challenges: each type of contract is unique, with its own size and trading rules, requiring a tie-up between commodities markets in different formats.13
To increase the viability of a commodities connect, it will be necessary for the various exchanges to establish listing, clearing and warehousing rules to unify settlement and delivery processes.14
Mainland China’s Response
The need for cooperation between the HKEx and the Shanghai Futures Exchange (“ShFE”) has been commented on in media reports, a partnership that is viewed as “vital” for any commodities link. At this point, it is uncertain whether the HKEx will champion this relationship. On the one hand, the ShFE states that it “will deepen cooperation with global exchanges”, while industry sources have stated that “the ShFE is “actively hostile” to the “connect” idea”.15 If the ShFE is resisting, this may be a result of the ShFE’s own involvement in the commodities trade; the ShFE runs China’s flagship copper contract and appears to be moving forward with plans to attract foreign investment flows. Additionally, China has been making efforts to internationalize its commodity markets through free trade zones, such as the Shanghai Free Trade Zone which backs the ShFE.16
Despite the practical challenges facing the commodities connect and the purported lack of warm response from the ShFE, analysts remain cautiously optimistic about its realization. First, the domestic derivatives market in mainland China is in its early stages, and therefore, a partnership with the HKEx would likely be conducive to development. According to Garry Jones, the CEO of the LME, the Shanghai Train has shown that the HKEx would be a good partner for the mainland exchanges to expand internationally.
Second, it is apparent that Beijing intends to further liberalize its capital account, while seeking greater influence over prices of key commodities. For example, Beijing has recently tripled the number of state owned firms permitted to trade commodities linked derivatives overseas without regulatory approval. According to a market strategist, this suggests that China will allow more inflows and outflows across its borders, while encouraging the use of derivatives for hedging purposes.17 The commodities exchange presents an ideal platform for China to achieve these goals, while providing a benefit to both the HKEx and LME.
Gold Connect as Touchstone
On July 9, 2015, while the pros and cons of the commodities connect were still being debated in Hong Kong and Shanghai, the establishment of a gold market connect between the two cities was kicked off by Hong Kong based traders’ purchase of two tons of gold from the Shanghai Gold Exchange.18 This self-initiated tie-up was lauded as a milestone, establishing a connection between the gold markets in Hong Kong and Shanghai: the Shanghai Gold Exchange and its Hong Kong counterpart the Chinese Gold and Silver Exchange Society of Hong Kong.
Having been planned for a year and recently approved by the Mainland Chinese authorities, the tie-up marks the first time members of the Hong Kong gold bourse may trade in the two markets of the Shanghai Gold Exchange. It is expected that the connection will encourage cross-border trading and help the Shanghai Gold Exchange expand its investor base through increased exposure to Hong Kong investors. As Haywood Cheung, the honorary permanent president of the Chinese Gold and Silver Exchange Society concluded, “it is important for the internationalization of the mainland gold market and the internationalization of the yuan”.19
Although only Hong Kong traders may purchase gold from Shanghai, and not vice versa, market-watchers are cautiously optimistic that Shanghai traders may soon be permitted to purchase gold in Hong Kong, creating an additional two-way flow of investment between the two cities.20
Full Steam Ahead?
Increasing integration between the HKEx and mainland China markets, either through the already implemented connections or proposed connections, is indicative of China’s desire to pursue its goal of internationalizing its currency and to open up its capital account. Although the market uncertainty that has resulted from China’s recent devaluation of the yuan (a decision that also highlights China’s intention to open its currency to market-driven movements) may slow down the implementation of future mutual market links, support for and confidence in the success of these connections has continued. According to Charles Li, the chief executive of the HKEx, a “bridge [between the exchanges] is already there; the tracks are laid, the trains have gone…The only thing that is going to slow down is the dispatch of the next couple of trains.”21