China -- and Chinese ETFs -- are getting a lot more interesting. And that, of course, is saying something.
Two big China stories shot across my bow this morning. First, Russell reported that "Greater China" (China, Hong Kong and Taiwan) now sports a larger market capitalization than Japan.
The incredible surge in China's A-share market, the class of shares available only to domestic Chinese investors, has lofted Greater China to the No. 2 spot in global market capitalization. According to Russell, the A-Shares market was up more than 100% during the first five months of the year, boosting Greater China's total market cap from $4.2 trillion in January to $5.6 trillion through May 31. That compares to about $5 trillion for Japan, which was flat over the same period.
(The fact raises an important point that investors who "diversify globally" with a developed-markets ETF don't realize: EFA, for instance, has a 1.72% position in "Greater China." For real diversification, you need both developed and emerging markets exposure.)
All of this is just a sidelight to the real story, however: China has decided to let domestic investors purchase stocks in Hong Kong. That has huge ramifications, both for the A-Shares market and for the "H-Shares" that us foreign investors can own.
Many people believe that the huge surge in the A-Shares market is a bubble. The definitive case for this was laid out recently by Heather Bell in her report on the HSI AH China Premium Index. The Premium index compares the value of companies in China that trade both "A-Shares" (available only to domestic Chinese investors) and "H-Shares" (available to foreign investors). As of July 31, for the 27 stocks that had both share classes, the A-Shares had, on average, a 64% premium over the H-Shares.
The explanation for the premium was twofold: 1) Domestic Chinese investors were not permitted to own foreign shares, so their rapidly growing wealth was forced into the A-Shares market; 2) Foreign investors were mostly not permitted to own A-Shares, so they couldn't exploit any arbitrage opportunity between the two classes of shares.
In the past few days, however, the Chinese government has ended the restrictions for domestic investors. The Financial Times reports that China's State Administration has launched a pilot project allowing mainland Chinese citizens to open accounts in Hong Kong, where they will be allowed to invest in all Hong Kong traded securities, including H Shares. The pilot program also removes restrictions that only allowed Chinese investors to own $50,000 in foreign currencies. In other words, the Chinese government has opened the floodgates to let the rapidly growing wealth in mainland China spill over into Hong Kong ... and eventually, the rest of the world.
The news sent Hong Kong's H-Share Index soaring, up more than 9 percent on Monday.The iShares FTSE/Xinhua China 25 ETF (FXI) -- which owns H-shares - is now up 14% since last Friday's close, as investors anticipate a rush of money into the H-share market.
The move won't necessarily end the A-Share premium, as you still cannot short A-share stocks. But if the government expands this pilot program, a long-term boom in the H-share market (and a pullback in A-Shares) could be in the offing.
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