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Getting caught between a rock and a hard place – Part 2

Historically, Hong Kong has long benefitted as a gateway between China and the Western world. Its role has become more important as China opened its economy since the 1980s. Hong Kong is effectively a de facto offshore financial centre for many mainland Chinese companies.

The pie chart below is taken from the latest fact sheet of the Hang Seng index, the blue chip stock market index of Hong Kong. About 40% of the index (in terms of market capitalisation) is made up of Hong Kong companies. The remaining 60% is Chinese companies listing as H shares or directly on the Hong Kong Exchange. The index now has 58 members, compared to 33 members previously. In total, over 30 members of the index are now Chinese companies. Heavyweights like HSBC, Cheung Kong, Hutchisons, Sun Hung Kai etc. have been overtaken by Bank of China, ICBC, Tencent and Alibaba.

Source: Hang Seng index,

This change in the composition of the index reflects an economic reality. China is now more important to the special administrative region than in the pre-1997 years. Business travel across the border is so important that the COVID-19 travel restrictions have been impacting the local economy. My friends are complaining how much income they have lost as they cannot travel back to China to conduct business meetings and close deals. You can understand why the Hong Kong government has to prioritise re-opening the border with China (which insists on pursuing a zero-COVID strategy) rather than pleasing Western business people in relaxing the 21 day quarantine measures.

But the increasing dominance of Chinese companies in the Hong Kong stock market has another implication for investors, especially for those who invest passively in the index. This is to do with the recent surprise changes on different fronts by the Chinese government. Some people claimed that it all started when the listing of Ant Financial, a subsidiary of Alibaba, was cancelled last year. The government wanted to show who is in charge, and has since then kept imposing different measures that hurt many Chinese technology firms.

President Xi has said that his domestic focus is to eliminate social inequality and improve the livelihood of Chinese citizens. On the international front, China will continue to demonstrate its national strength, especially in front of the US.

These policy priorities mean that there can yet be more domestic measures that could affect different Chinese companies and sectors. Equally, the risk of escalating tension with the West will add another layer of uncertainty to investing in Chinese stocks. Index investors should be aware that the performance of Hang Seng index will continue to be weighed down by these issues.

Are there any alternatives? Some “old style” Hong Kong companies may look interesting, especially from a valuation perspective. However, the local Hong Kong economy is closely tied to China. Earnings from many local Hong Kong companies may continue to suffer if the border remains closed. An example is Cathay Pacific, which is one of the best airlines in Asia but has been suffering from the sharp reduction in travel between Hong Kong and China. Perhaps it is better to wait to see when the border between Hong Kong and China reopens.

Property companies in Hong Kong used to be popular among investors. High housing prices in Hong Kong should give support to these companies. But there is a risk, albeit it looks low at the moment, that the Hong Kong government may need to follow President Xi’s vision of reducing social injustice. Interventions to control property prices in Hong Kong? Never say never.

To conclude, because Hong Kong is caught between a rock and a hard place, investors should consider whether their investments will end up in a similar situation: suffering from uncertainties over both Chinese domestic policies (and economy) and the tension with the Western world. Other countries in Asia may benefit from Hong Kong’s situation, and investors can look at these markets as an alternative.

James Chu CFA

Head of Investment Solutions

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