Southbound flows through Shanghai–Hong Kong Stock Connect picked up visibly in the past few weeks, especially after the approval of Shenzhen–HK Connect was announced in mid-August. Meanwhile, China saw a widened decline in its FX reserves in September, pointing to increased capital outflows.1 Have Stock Connect flows contributed to the decline of FX reserves or put pressure on the renminbi? If so, how?

The Connect is a closed loop for investors but still a channel for cross-border capital flows between the two markets. By design, money put into Stock Connect by investors will be locked in the securities market and cannot be used for other purposes. Capital gained from the sale of securities cannot remain in the local market but should return to its originating account. Mutual market access by investors is enabled only via the exchange and clearing houses in their home market. For clearing and settlement, ChinaClear and Hong Kong Securities Clearing Corporation (HKSCC) become each other’s special clearing participants and settle cross-boundary trades on behalf of their home investors.

Thus, Stock Connect flows do involve currency conversion, except it is handled by the clearing houses. Under Stock Connect, investors use home currencies to invest in the other market, while ChinaClear and HKSCC are responsible for the cross-boundary fund flows and currency exchange. These are completed by QDII/QFII institutions under the QDII and QFII schemes, a sharp contrast. It is a key feature of the Connect that all RMB-HKD FX trades must be done offshore in Hong Kong. In light of these arrangements, ChinaClear will need to sell RMB in Hong Kong to buy HKD for settlement of southbound investments, putting pressure on CNH to weaken. A weaker CNH would drag down CNY due to arbitrage forces and/or expectation realignment. If the PBoC wants to offset the exchange rate effect, it would have to sell FX reserves to support the RMB. In this aspect, southbound flows are not very different from conventional capital outflows: leading to currency depreciation, reserve drawdown, or both.

In practice, southbound flows only have a limited impact on China’s currency or reserves:

Southbound flows are small relative to China’s FX reserves and CNH market turnover. In September, southbound flows reached the largest Rmb50.7bn (~US$7.6bn) since the launch of the scheme, at 40.4% of the monthly decline in China’s reserves. However, the cumulative amount of net outflows of RMB to HKD through the Connect is Rmb150.0bn (~US$22.3bn) since launch or Rmb125.1bn (~US$18.6bn) YTD, both less than 1% of China’s FX reserves. The BIS survey data show that the average daily trading volume for CNH spot, swaps, forwards, and options combined was as high as Rmb500.1bn (April 2016). An extra supply of ~Rmb3.2bn a day (the September average) from southbound flows should have a relatively small impact on the price of CNH.

One-way flows cannot persist for long. Southbound flows hinge on the valuation of stocks in Hong Kong, especially the price differentials between dual-listed A- and H-shares, which have narrowed considerably after the recent HK market rally. HK stocks have a market-based issuance system and are mainly priced by institutional investors; the market forces will respond to any potential overvaluation and render the one-way bet unsustainable. In addition, southbound flows tend to increase with RMB depreciation expectations―a potential reaction to the latter. While a further strengthening of the USD could put downward pressure on the RMB, we believe China should and probably will avoid a sharp depreciation of its currency in 4Q16 and 2017. More importantly, China-related shares, a large part of the HK market, are not an effective hedge for China’s currency risks. Arbitrage activities will thus reverse the trend of one-way flows at some point in time.

Moreover, present southbound flows will add to future demand for the RMB. Under the closed loop system, the funds will be converted back to RMB after the sale of HK shares, and the average holding period of Chinese investors in the domestic market is only ~100 days (YTD). In this regard, the impacts of Stock Connect flows on China’s currency or reserves are only transitory.

In conclusion, capital outflows through the Connect need to be carefully monitored, but their FX impacts are generally manageable.