At the beginning of every Chinese New Year, AsianInvestor makes 10 predictions about economic, political and financial developments that are likely to have an impact on the way institutional investors assign their money.

The third Year of the Pig outlook question shines a light on the ETF Connect between China and Hong Kong.

Will the ETF Connect between China and Hong Kong finally open?

Answer: No

The idea of a Connect scheme for exchange-traded funds (ETF) was officially touted by regulators in China and Hong Kong as early as 2016, before the launch of the Shenzhen-Hong Kong Stock Connect in December of that year.

Hong Kong Stock Exchange (HKEX) chief executive Charles Li said in a presentation in August 2016 that ETFs would be included in the Connect schemes in 2017. These plans faltered; in June 2017 Li admitted in a media interview that the financial regulators of China and Hong Kong had “to find terms they are comfortable [with]” before pressing ahead with the scheme.

Hopes of that ETF Connect would launch were reignited in early 2018 following news that Hong Kong would introduce a northbound investor identification scheme, which got off the ground on September 26. Under the model, brokers have to assign a unique number to each investor using the connect scheme for northbound investments.

This so-called see-through model allows regulators to identify each investor, and long been in place within China. Indeed, market observers told AsianInvestor they believed introducing an investor ID scheme was a prerequisite for ETF Connect, as China's regulators want to harmonise the two markets as much as possible before rolling out a new mutual access scheme.

However, hopes that ETF Connect would soon follow did not survive for long. In December, the newly-appointed Securities and Futures Commission (SFC) chairman Tim Lui admitted there was an absence of agreement on ETF Connect and as a result, the regulator had “decided to shift our focus to launch the ETF cross-listings”.

“The trading and settlement methods for ETFs between Hong Kong, Shanghai and Shenzhen are all very different. It will need a very long period of discussion to establish the infrastructure to build an ETF Connect,” Lui added.

One stated reason for the delay is the difference in settlement times between the two markets. Chinese ETFs operate on a ‘T+0’ basis (ie. they are traded and settled on the same day) while in Hong Kong they operate on ‘T+2’ (they are settled two days after trading).

LISTING LIMITATIONS

Observers believe there is a deeper reason for the continual delay.

“My thoughts are the SFC and HKEX have different agendas. Charles Li has been talking about ETF Connect for [many] years and we are no further forward, and the SFC seems to be playing interference in a very logical development for China,” the chief executive of a Hong Kong-based asset manager told AsianInvestor.

One possible explanation is that the Shanghai Stock Exchange (SSE) will only agree to proceed on ETF Connect if Hong Kong excludes international ETFs listed in the territory. If true, it’s likely the SSE’s demand is down to ambition; it wants international ETFs to directly list with it, rather than having to act as a proxy for HKEX-listed international products.

It’s unlikely the HKEX would agree to such a demand because it would heavily limit the appeal of ETF Connect with Chinese investors. Indeed, the Hong Kong stock exchange operator is already understood to be unenthusiastic about the fact that ETF Connect would, as proposed, only include Hong Kong-domiciled ETFs and exclude cross-listed funds.

It would make sense were the scheme’s delay to be down to a bun-fight between the SSE and HKEX rather than settlement issues. After all, Stock Connect settlement issues were resolved to a sufficient degree that it could proceed, and ETFs are a form of share product. As the CEO noted, the two exchanges could fairly easily modify their standards to meet T +1 settlement through the creation of a cash recognition unit.

The possibility that it’s a bureaucratic or political disagreement holding up ETF Connect also makes it hard to predict when these problems could be resolved. But to judge by comments from the HKEX and SFC, it’s unlikely to be soon.

An HKEX spokeswoman denied that plans for ETF Connect are on the back burner, but wouldn’t specify when the scheme could launch. “Connecting issuers and investors in China and Hong Kong via ETF Connect remains a key HKEX market development priority, and we remain focused on delivering a successful ETF Connect,” she told AsianInvestor.

The SFC appears even less optimistic. “We have been working with the China Securities Regulatory Commission as well as mainland and Hong Kong stock exchanges on ETF Connect. It is premature to comment further," a spokesman for the financial watchdog told AsianInvestor.

The lack of confidence in these statements suggests there are few signs of an imminent resolution to the problems holding up ETF Connect. As a result, we predict the scheme will not open this year – much to the disappointment of Hong Kong’s ETF industry and Chinese investors seeking more overseas investment exposure.

Previous Year of the Pig predictions: 

How much will Asian asset owners increase alternative asset allocations (on average)?

Will the US economy suffer a major downturn?