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Individual American investors will likely get direct access to Chinese stocks on the Shanghai exchange for the first time starting this month. But playing those Chinese markets will come with risks.
A program called "Shanghai-Hong Kong Stock Connect" will give foreign investors to access 568 Shanghai stocks, called A-shares, through the Hong Kong Stock Exchange. Conversely, Chinese investors will be able to trade Hong Kong's stocks, known as H-shares, through the system.
Fewer than 70 firms are cross-listed on both exchanges. The system is expected to be launched late this month, though no formal date has been set for its debut.
"This is a channel by which a retail investor in Idaho or Ohio can buy A-shares in Shanghai in a similar manner as they could buy shares in New York," said Alfonso Martin, global head of Asian flows for Citibank in Hong Kong. "It's a game changer."
Since 2003, selected major institutions have had access to A-shares under China's "Qualified Foreign Institutional Investor" program (QFII), but Stock Connect will open about 90 percent of Shanghai's total market capitalization to global investors.
"Stock Connect will allow smaller trading firms and hedge funds to access [the] A-share market, because these firms were often not reaching requirements of the Qualified Investor programs," said Denis Suslov, a Shanghai-based finance analyst who also runs a QFII data website called China-XBR.com.
American investors can already buy A-shares through a handful of ETFs such as Deutsche X-trackers Harvest CSI 300 China A-Shares. With the new link between Hong Kong and Shanghai, "investment will likely become cheaper and easier," Suslov said.
Although Stock Connect will loosen restrictions on A-share trading, QFII license holders will still retain certain advantages, such as being able to take part in Chinese IPOs and invest in the Shenzhen exchange.
Stock Connect also will not allow intraday trading, and all investors must predeliver their orders, meaning A-share purchases and sales must occur during separate trading sessions.That means two consecutive days of open markets for a smooth transaction.
But variances between the two Chinese cities' holiday and operating schedules—as well as Hong Kong's typhoons—could disrupt markets, leaving foreign investors helpless while their holdings advance or decline significantly on the mainland.
Physical distance between the United States and Asia adds additional risk, as investors must work around time zone differences and the often-limited knowledge of the Chinese firms.
Then, there's Chinese companies' financial and operational transparency, which has a spotty track record. Mainland Chinese firms are not subject to—or don't follow—U.S.- or European-style standards of financial reporting and other forms of compliance.
Clem Miller of Wilmington Trust Investment Advisors warned that Chinese firms have shown poor transparency, but he and other analysts, including Michelle Gibley, director of international research at Charles Schwab, said they hope corporate vigilance will improve with A-share access through Hong Kong—which has stronger accounting standards than the mainland.
Despite the few operational uncertainties, most analysts are optimistic on the Shanghai-Hong Kong Stock Connect's ultimate benefits of internationalization of the yuan and added liquidity to the global market.
"It's like water," said Marti G. Subrahmanyam, professor at NYU's Stern School of Business, said. "So long the floodgates have been kept closed and water could not flow from China to Hong Kong. They are slightly opening the floodgates."
Even after finding a brokerage, investors must weigh Stock Connect's many restrictions, especially the low trade quota. "It's better than nothing," said David Friedland, Interactive Brokers' Asia-Pacific managing director. "I don't love it, but it's certainly big enough to get through a portion of the day."
For the U.S. retail investor, finding a brokerage that can trade A-shares on the Hong Kong exchange once the program launches may prove the greatest challenge.
Although there are roughly 500 registered exchange participants in Hong Kong, only about 100, including Citibank, have actually completed the system upgrades necessary to take part. A Hong Kong Stock Exchange spokesperson said those firms account for about 80 percent of the total securities market turnover, and an official list of participants will be released before the launch of Stock Connect.
Likewise, many major U.S. financial institutions may offer foreign investment services, but only a few firms offering retail services have confirmed that they'll participate, among them Citibank and Interactive Brokers.
"A majority of other U.S. brokerages have reduced or removed international services due to challenging U.S. rules and regulations that only seem to become more difficult to navigate as time goes on," said Brandon Reinkensmeyer, co-founder of brokerage review website Stockbrokers.com.
Trades on the upcoming connection must be transacted in Chinese yuan, so if a client does not have an account in yuan in Hong Kong, the financial institution will likely make a foreign exchange transaction as part of the trade order, or offer a yuan loan.