H-share circulation and HK market reforms

China Securities Depository and Clearing Corporation and the Shenzhen Stock Exchange jointly issued the Detailed Rules for the Implementation of the Pilot Business of Full Circulation of H Shares (Trial Implementation) on 20 April. The implementation rules regulate the registration, depository, transaction and settlement of H-share full circulation, the implementation of which shows that the H-share full circulation pilot system is on track and of great significance.

In 1993, the Hong Kong Stock Exchange amended the Hong Kong Stock Exchange Listing Rules to allow state-owned enterprises (SOEs) to be listed on Hong Kong Stock Exchange and issue H-shares. According to these listing rules, H-shares refer to overseas listed foreign shares listed on the Hong Kong Stock Exchange. On 4 August 1994, the State Council promulgated the Special Rules concerning Floating and Listing of Shares Overseas by Companies Limited by Shares, which stipulate that shares of companies limited by shares that are raised from overseas investors and listed on overseas stock exchange are overseas listed foreign shares. If such shares are listed on the Hong Kong Stock Exchange, they are H-shares.

Under the current listing structure, H-shares issued after listing in Hong Kong can be freely circulated. Shares that come from investment in such companies by foreign capital before listing (unlisted foreign shares) can be converted to H-shares upon application and approval, and then can be circulated. Foreign shares denominated in renminbi and subscribed in currencies other than renminbi (i.e., B-shares) may also be converted to H-shares. Except for those situations, shares held by other domestic shareholders are all recognized as “domestic shares” and can only be transferred through agreements between Chinese legal entities, natural persons, qualified foreign institutional investors, and strategic investors, and cannot be circulated and cashed out on the Hong Kong stock market.

Full circulation of H-shares refers to the shares held by domestic shareholders of H-share-listed companies in Hong Kong allowed to be converted to H-shares, and transferred and circulated. Prior to full circulation, if shareholders of H-share-listed companies – but not listed on the Chinese domestic stock markets that are Shanghai and Shenzhen stock exchanges – want to reduce their holdings of domestic shares, they must wait until the company is listed on the Chinese domestic stock market (A-share market) and the lock-up period is over. After the full circulation of H-shares, the domestic shares can be converted to overseas-listed foreign shares (H-shares) and be directly traded on Hong Kong stock market.

Policy implications. The full circulation policy of H-shares has a great influence on Chinese companies’ decision to be listed in Hong Kong. The full circulation of H-shares reduces the cost and difficulty of the pre-listing restructuring of companies intending to list in Hong Kong, and increases the enthusiasm of the companies in mainland China to list in Hong Kong.

The fact that shares held by domestic shareholders of H-share-listed companies cannot be fully circulated is the most unacceptable issue to domestic shareholders. With the upcoming trial of the full circulation system, companies in mainland China have greater enthusiasm for listing. In particular, foreign shareholders in Sino-foreign joint ventures can directly apply to convert their shares to overseas-listed foreign shares at the time of listing, which increases the liquidity of their shares. Nevertheless, the domestic shareholders may choose the right time to apply for full circulation to realize the full value of their shares.

The full circulation of H-shares can also relieve the pressure and financial difficulties of major shareholders, and break the embarrassing situation in which domestic shares cannot be mortgaged or cashed out, and equity pledged financing is limited. Under the background of H-share full circulation, domestic shareholders may choose to issue H-shares first. If the Hong Kong stock market is in a good situation, they can apply for full circulation. If the Hong Kong stock market is depressed, domestic shareholders can choose to issue renminbi ordinary shares (A-shares) in the domestic stock market.

Under the background of H-share full circulation, companies established in mainland China have another choice to go public on the international stock market. It can be said that the spring of H-share companies has come! However, due to the high price-to-earnings (PE) ratio in the domestic stock market, seeking a high premium is the eternal pursuit for many Chinese companies.

Companies that meet the conditions for listing on the domestic capital market (A-shares) still regard the A-shares market as their first choice. However, under the current environment, that mainland securities authorities adopt a strict approval system, listing on the Hong Kong capital market as H-share companies is a better choice for companies in mainland China.

The full circulation of H-shares will have a major impact on the Hong Kong stock market as well. The current full circulation of H-shares can be compared with the A-share split share reforms many years ago. At the beginning of the establishment of the capital market in those years, in order to establish it as soon as possible, China adopted the equity splitting mode of “trading of state-owned assets without listing and increasing the circulation of floated shares”. The shares were artificially split into non-tradable and tradable shares. The implementation of the “same shares with different rights” policy leads to a situation that the state-owned shareholders holding non-tradable shares are usually in a controlling position. At the same time, this equity splitting model also causes serious deficiencies in the governance structure of listed companies.

For example, it is common that the abuse of control power by controlling shareholders infringes the interests of small and medium shareholders. China’s reform of this split share structure model in 2005 was equivalent to achieving full circulation, and promptly aroused the enthusiasm of the market. Therefore a famous bullish domestic capital market began in 2007.

The “domestic shares” under the current H-share structure are almost the same as the “state-owned shares” under the A-share split-share model. However, the A-share split reform at that time had a considerable policy guidance component, while the background and motive of the current full circulation of H-shares is completely different.

On the one hand, the full circulation of H-shares has increased the wealth of majority shareholders of H-shares companies, and the majority shareholders therefore have more incentives to support share prices. On the other hand, with more and more shares trading in the market, the stock market’s liquidity also increases significantly. There may be divergence in a company’s value and its stock price in the future, but the maturity of the company’s business model and its profitability will ultimately determine the tendency of its stock price.

Video is in Mandarin

Fan Xingcheng is a senior partner at Dentons