Introduction
The recent market turmoil has bruised Chinese offshore investors disproportionally relative to their onshore counterparts.
Quiet days in the Chinese equity markets are few and far in between. Even then, the last few months have proved extremely eventful. Since the last-minute suspension of Ant Group’s initial public offering last year, a series of anti-monopoly, data security and industry-specific regulatory changes have been introduced in China.
The recent market turmoil has bruised Chinese offshore investors disproportionally relative to their onshore counterparts as most of the impacted companies are listed offshore (Figure 1). It even sparked debates about whether China’s equities are still investable, even though the sheer size of Chinese listings makes it a ‘not if, but how’ question, in our view. We have previously discussed the benefits of investing in China A-shares from both asset allocation and alpha generation perspectives.
In this article, we look at both the onshore and offshore markets’ historical performance, fundamentals, market/regulatory risks, and investors’ positioning following the recent volatilities.1 The takeaway in one line is that while regulatory risks are likely to stay elevated, onshore Chinese equities are more attractive than offshore for investors.
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Source: Bloomberg; as of 30 September 2021.
Onshore Chinese equities represented by CSI 300 Index; offshore represented by offshore Chinese listings within MSCI EM.
Performance
Both onshore and offshore Chinese listings experienced meteoric growth in the past decade. The market is now too big to ignore, with the combined market cap standing at USD14 trillion2 (Figure 2). Historically much smaller, the offshore market has grown on par with the onshore market, largely driven by the booming offshore IPOs – itself driven by more relaxed listing rules in both US and Hong Kong.
We expect the attractiveness of listings in the US, and offshore more broadly, to wane over time.
In fact, contrary to many investors’ impression that onshore Chinese listings had a lost decade in the 2010s3, the China A-share market has generated similar returns relative to the offshore listings, though without the fanfare that often comes with the once invincible Chinese tech giants listed offshore (Figure 2). With both Chinese and US regulators tightening the screw on Chinese listings in the US, and continuous IPO reforms underway in mainland China (such as the reforms of ChiNext, the launch of the STAR board and the proposed launch of the Beijing Stock Exchange), we expect the attractiveness of listings in the US, and offshore more broadly, to wane over time. In particular, companies that are more likely to enjoy policy support (and thus less regulatory risks) will choose onshore exchanges as the primary IPO venue, in our view.
Figure 2. Chinese Onshore Versus Offshore Market Cap/Cumulative Performance
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Source: Bloomberg, MSCI, CSI, Man Numeric; as of 30 September 2021.
Fundamentals
Onshore listings have transformed in recent years. No longer a market dominated by financials, energy and industrials, ‘new China’ sectors now make up half of the onshore market capitalisation.
One appealing aspect of offshore Chinese listings is that they often provide exposures to the most innovative sectors of the Chinese economy – those that benefit the most from the emerging middle-class. If we define consumer staples, consumer discretionary, health care, technology and communication sectors as the ‘new China’ and the rest as ‘old China’, offshore listings consist of primarily ‘new China’ sectors. At its peak in 2021, ‘new China’ sectors accounted for almost 80% of the overall offshore listings (Figure 3). However, onshore listings have also transformed in recent years. No longer a market dominated by financials, energy and industrials (as was the case about 10 years ago), ‘new China’ sectors now make up half of the onshore market capitalisation.
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Source: MSCI, CSI, Man Numeric; as of 30 September 2021.
With most regulatory actions impacting companies in the ‘new China’ sectors, forecast earnings growth for offshore listings has slowed down significantly.
With swirling uncertainties driven by geopolitical tensions, the Covid-19 pandemic and increased regulatory scrutiny, we believe investing in the onshore markets helps investors maintain a more balanced sector exposure, while still benefitting from the most dynamic sections of the Chinese economy. With most regulatory actions impacting companies in the ‘new China’ sectors, forecast earnings growth for offshore listings has slowed down significantly. However, the onshore market, supported by strong cyclical rally fueled by a global economic recovery, is having the strongest earnings momentum in the last decade (Figure 4).
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Source: MSCI, CSI, IBES, Suntime, Man Numeric; as of 30 September 2021.
Risks
In addition to the more diversified sector exposures, onshore Chinese equities are less risky from a regulatory perspective. Mostly relying on the Variable Interest Entities (‘VIE’) structure to circumvent certain foreign capital restriction in China, offshore Chinese listings face increasing scrutiny from both Chinese4 and US5 regulators. With US-China geopolitical tensions lingering in the background, the fate of offshore Chinese listings, particularly those listed in the US, remain up in the air.
On the other hand, onshore Chinese listings have to go through extensive regulatory vetting during the IPO process. This is because regulators seek to protect retail investors, who have historically been the primary participants in the Chinese equity market. Take the Shenzhen Stock Exchange as an example. Any company looking to list on the main board needs to meet a high listing requirement (a company history of more than three years and net profits exceeding RMB30 million in the previous three years before the IPO)6 before going through a lengthy and complicated process7 that involves broad due diligence responsibilities on the underwriter and an ultimate approval from Chinese Securities and Regulatory Commission.
The difference in listing processes have been highlighted in recent market events.
The difference in listing processes have been highlighted in recent market events. Ant Group’s dual listing in Shanghai and Hong Kong was halted at the last minute, while the probe on DIDI was launched following its debut in the US.8 Similarly, Evergrande8 wasn’t able to secure onshore equity financing in November 2020, which eventually led to the liquidity crisis that sends shock waves across the global financial system.
From a market risk perspective, the elevated level of volatility has been a hallmark of the China A-share market, with the boom-bust cycle of 2015 still vivid in investors’ memory.
However, there has been a gradual institutionalisation in recent years, driven by the introduction of the Stock Connect and the increasing presence of domestic institutions. This has resulted in the China A-share market’s volatility dropping to a level that’s comparable to offshore listings (Figure 5), which is more exposed to frequent shifts in foreign investors’ sentiment.
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Source: Bloomberg, MSCI, CSI, Man Numeric; as of 30 September 2021.
Finally, the upcoming launch of MSCI China A 50 Connect Index Futures on Hong Kong Stock Exchange9 is another milestone in the China A-share market’s development, providing global investors a long-awaited financial instrument to effectively manage the beta risk.
Investors’ Positioning
With regulatory changes gripping the market, both international and domestic investors remain confident in onshore listings, while wary about the offshore.
In the onshore market, international investors are undeterred by the recent swings, as evidenced by continuous net inflows (Figure 6). The cumulative Stock Connect inflows reached more than CNY1.4 trillion as of the end of the third quarter of 2021, an all-time high and a net increase of CNY300 billion from the start of this year. Compared with the previous macro events that have led to foreign outflows, such as US-China trade tensions in 2019, the Covid-19 outbreak and the subsequent global markets meltdown in March 2020, the regulatory tightening hasn’t worried foreign investors as much in the onshore market. Similarly, the total amount of outstanding margin loans used to finance onshore investors’ long positions, historically a good indicator of the onshore market sentiment, has continued to rise (Figure 7).
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Source: Hong Kong Stock Exchange, Shanghai Stock Exchange, Shenzhen Stock Exchange; as of 30 September 2021.
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Source: Shanghai Stock Exchange, Shenzhen Stock Exchange; as of 30 September 2021.
In the offshore market, the flow of domestic capital into Hong Kong listings via the Stock Connect – which went vertical in 2020 and early 2021 – is now leveling off (Figure 8) following the offshore market rout.
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Source: Hong Kong Stock Exchange, Shanghai Stock Exchange, Shenzhen Stock Exchange; as of 30 September 2021.
In the offshore market, the flow of domestic capital into Hong Kong listings via the Stock Connect – which went vertical in 2020 and early 2021 – is now leveling off.
Foreign investors are also becoming more wary about offshore listings, with some derisking evidenced in the price chart of offshore Chinese listings in the past few months. Although we’re yet to see a concerted move to start shorting, it’s potentially also a sign that the heightened uncertainties in the offshore market have led to less participation from short sellers (Figures 9-10).
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Source: IHS Markit, Man Numeric; as of 30 September 2021.
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Source: IHS Markit, Man Numeric; as of 30 September 2021.
Conclusion
Foreign investors are also becoming more wary about offshore listings, with some de-risking evidenced in the price chart of offshore Chinese listings in the past few months.
As the second-largest equity market in the world, Chinese listings are too big for global investors to ignore. And with increasing regulatory risks, investors need to take a more thoughtful approach as to what China exposures to take in their portfolios.
In the broader Chinese equity markets, we believe the relative importance of the onshore market is likely to continue to grow. In light of the recent regulatory actions in China and a potentially bumpy road ahead, onshore listings offer similar historical performance, more balanced sector profiles, brighter earnings prospect and potentially fewer regulatory headwinds than their offshore counterparts. As such, we believe the onshore Chinese equity market is a better venue for investors to gain exposure in their portfolios.
1. We use the CSI 300 Index constituents and offshore Chinese listings in MSCI EM Index (rescaled to sum to 100%) as proxies for onshore and offshore Chinese equity markets, respectively. Note that there is overlap between the two due to the existence of A-H dual listings, but it wouldn’t make a material difference to the analysis.
2. This is actually an underestimate of the overall market capitalization as it only includes CSI 300 Index and offshore Chinese listings in MSCI EM Index.
3. Shanghai Composite Index indeed experienced a lost decade, but it’s not representative of the overall market.
4. Reuters’ report on Chinese regulators to require companies looking to list offshore to obtain approval: https://www.reuters.com/world/china/china-targets-offshore-ipostructure-require-ministry-approval-sources-2021-07-08/
5. SEC Chair Gary Gensler’s statement related to offshore Chinese listings: https://www.sec.gov/news/publicstatement/gensler-2021-07-30
6. See the listing standard on Shenzhen Stock Exchange: http://www.szse.cn/English/listings/standards/index.html
7. See the listing process on Shenzhen Stock Exchange: http://www.szse.cn/English/listings/process/index.html
8. The organisations and/or financial instruments mentioned are for reference purposes only. The content of this material should not be construed as a recommendation for their purchase or sale.
9. See more details: https://www.hkex.com.hk/Products/Listed-Derivatives/Equity-Index/ MSCI-Indexes/MSCI-Indexes/APAC-Emerging-Market-Single-Country/Price-Return/MSCI-China-A-50-Connect-(USD)-Index-Futures?sc_lang=en
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