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China's CDRs fall at the second hurdle

Further problems for Xi's financial reform program

The Hong Kong stock exchange CEO Charles Li faces an uphill battle after the CDR debacle.   © Reuters

Last week brought the somewhat disappointing listing of Chinese mobile phone maker Xiaomi, minus its proposed offering of China depositary receipts. This week amounted to a knock on top of a bruise for the CDR program. The Hong Kong stock exchange was somewhat surprised that the mainland exchanges had ruled out Xiaomi and potentially other companies issuing shares with weighted voting rights from being eligible for the Stock Connect scheme, the trading link between Hong Kong and mainland Chinese equity markets. It had been assumed that they would be included and the Hong Kong exchange had suggested so at the time of the Xiaomi IPO.

After a rushed trip to the mainland, Charles Li, the chief executive of the Hong Kong exchange, claimed victory, saying there had been a misunderstanding and that an agreement had been reached. His exchange announced as much on its website, stating that companies with weighted voting rights would be eligible for inclusion after a "Special Stability Trading Period." But such an assurance was missing from the Chinese versions. This was not a translation issue, but a deliberate omission.

Charles Li has been successful in trying to ensure that the Hong Kong exchange has remained relevant as the Chinese mainland markets grew ever larger. The Connect scheme was a genuinely innovative development on the part of the exchanges. Whether or not weighted voting rights are worthwhile and fair is debatable but Li has been able to get these approved, allowing the Hong Kong exchange to challenge the U.S. for new tech listings.

But he now faces an uphill battle. Hong Kong in some ways can never compete with the mainland exchanges, which are integral to the Chinese domestic financial system in a way that the Hong Kong exchange is not.

There is a basic question, too: If any large enough Hong Kong-listed company is eligible for Connect, then why do they need CDRs in the first place to secure mainland investors? The CDRs can be useful for companies listing in the U.S. but not for Hong Kong. This question was never really asked or answered as the Xiaomi bandwagon rolled along during June but it is apposite now. The answer is, of course, that they are not needed for Hong Kong listings.

The most contentious issue around CDRs was to ensure that there is no meaningful price differential between the offshore listing and the CDR. Connect has already addressed those concerns.

The CDR debacle highlights very real divergence between the Hong Kong and the mainland exchanges and regulators. The mainland exchanges rightly want trading volume and exposure from the listing of CDRs. Connect has helped them reach more investors but China's Qualified Foreign Institutional Investor (QFII) scheme, a transitional arrangement that allows institutional investors who meet certain criteria to invest in a limited scope of cross-border securities products, also remains a major channel for foreign investors. Neither Shanghai nor Shenzhen wants to give too much ground to Hong Kong.

The China Securities Regulatory Commission remains overly cautious on CDRs. The regulator sees its role as protecting investors in China and if the CDR wasn't acceptable last week in the name of investor protection, then it makes sense to restrict the shares via Connect this week. But arguing that mainland investors are unfamiliar with weighted voting rights companies is a weak argument. How will they ever become comfortable without exposure? What does being comfortable even mean? Investors are primarily interested in capital gains; they see a company they know and want to benefit from its growth. They aren't voting their shares anyway in most cases, so the investor protection argument is a red herring.

The past few weeks has shown how direction from the top to open up and reform clashes with the reality of implementation on the ground. Nothing should be taken for granted, as the Hong Kong exchange has found out.

Hong Kong certainly has some right to feel aggrieved but the different English and Chinese language versions of its press release are disturbing. What were they doing? Do they want to sound more positive for the international audience than for the mainland one? How clumsy. Understanding market development in China is hard enough without the Hong Kong exchange muddying the waters. And which press release is correct? Time will tell but reputational damage has been needlessly incurred.

The Hong Kong exchange is always going to be on the back foot when it comes to being a conduit to the mainland. Its advantage remains the mainland's slow pace of opening up market access and embracing a market-driven approach for listings. When H shares -- shares of Chinese mainland companies listed in Hong Kong but regulated by Chinese law -- launched 25 years ago, Hong Kong could provide a platform to reach a global investor base at a time when neither Shanghai nor Shenzhen could. Those days are past. Shanghai and Shenzhen can compete on the global stage, but only if allowed to do so by their political overlords. Stock Connect is a groundbreaking facility but its ability to grow is limited because its fate lies ultimately in the hands of Beijing.

The CDR program was the showcase reform of the Chinese equity market this year; foreign ownership of financial institutions was also significant but its effects are long term. CDRs were immediate and high profile. These past two months have given Xi Jinping's reform program a black eye.

Too much effort has been invested in the program for it not to work eventually, but these early missteps could have been avoided. The confusion and contradictions have given an insight to some of the rivalries and infighting which are all part and parcel of reform in China.

Fraser Howie is co-author of "Red Capitalism, The Fragile Financial Foundations of China's Extraordinary Rise." He has worked in China's capital markets since 1992.

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