Get ready to board China’s reform train

Iwas pleasantly surprised to hear the good news first hand from Premier Li Keqiang at Boao Forum that investors on the Chinese mainland and in Hong Kong will soon be able to trade shares on each other’s stock exchanges. The announcement is beyond adding weight to the importance of the scheme; it underscores Beijing’s strong determination for reform.

The Shanghai-Hong Kong Stock Connect, or the “Through Train Program” (TTP), likely to be launched in six months, is a significant step toward the opening up of China’s capital account.

Allowing cross-border capital flow, the program is a long-awaited, missing ingredient in the internationalization of the renminbi. Until now, the liberalization of China’s currency has primarily focused on the economy’s current account, especially on trade and direct investments.

Since the country’s newleadership took office last year, there has been a noticeable acceleration in the pace of reforms. The Shanghai-Hong Kong linkage is among a plethora of newmeasures rolled out by the government at a breathtaking pace. Over the past few months, we have seen a widening of the renminbi trading band, the end of the central bank’s control over bank lending rates and the launching of Shanghai’s pilot free trade zone, which has opened two-way corporate payment flow.

The program is also a move to quench the thirst of investors for Chinese assets, which have hitherto been inaccessible. Hong Kong, the leading offshore renminbi center, will soon become the choice connector bridging the two ends of a heavy dumbbell— on one side, global investors, who will gain direct access to the mainland’s stock market, and, on the other, tens of millions of mainland residents keen to diversify their assets.

The TTP allows mainland investors to trade inHong Kong shares up to a quota of 250 billion renminbi ($40.08 billion), andHong Kong investors to trade in Shanghai-listed shares up to 300 billion renminbi. Up to now, access to the mainland’s A-share market has been limited to licensed institutional investors going through the Qualified Foreign Institutional Investor and Qualified Foreign Institutional Investor quota schemes. The newprogram provides a more direct and flexible means for investors, including retail investors, to trade in Shanghai-listed shares without the need for going through fund managers.

Like most reforms, every change will bring about knock-on effects. As a start, the program may narrow the valuation gaps between the Shanghai andHong Kong equity markets. The 20,000 renminbi conversion cap may become the next regulatory consideration in the mainland’s pipeline. Listing inHong Kong may present a fresh appeal to foreign issuers. And given that the scheme is denominated in renminbi, the implicit convertibility of the currency has never been clearer. These are all plausible suppositions to be borne in mind.

Skeptics may argue that the quotas set by China limit the scale and relevance of the TTP. But it is important to note that the quotas are net amounts, not gross, and that underlying trading value can be many times greater.

For policymakers, it is easier to bring about changes when a market is either fully open or fully closed. It is a different matter when a market is trying to move from one spectrum to another, where far more risks need to be taken. It is true that by imposing quotas, China has stopped short of completely opening-up of its capital account. Yet, quotas are necessary to manage the transition from a closed economy to an open one— not to mention this is an economy worth 57 trillion renminbi and second in size only to the US. Even the smallest degree of change in China’s policy could have tectonicshift implications for it, and send ripple effects in markets across the world.

China always moves one step at a time, starting small newprograms and expanding them in an orderly manner when the time is right. To be successful, the TTP will need expanding and it may prove difficult to achieve the desired results without going all the way.

The opening of stock trading will bring about a different approach to the QFII/Qualified Domestic Institutional Investor arrangement. QFII offers a newavenue to directly invest in mainland andHong Kong stocks, while QDII still has its intrinsic portfolio value as it spans across a wider spectrum of investment alternatives, including bonds and futures.

On the horizon is also the introduction of a “mutual recognition” program which would allowHong Kongbased mutual funds to raise money from mainland investors and vice-versa. All these are progressive examples of China’s willingness to experiment different policy variations in the journey to open up its economy.

The TTP is part of China’s bigger reform train that has a strong forward momentum and no reverse gear. It should be clear that the opening up of China’s capital account is an irreversible journey, just like the internationalization of the renminbi, which has taken place at breakneck speed over the past fewyears.

This program is not perfect, though. Questions will be asked on and concerns voiced over the application quota, and what happens when quotas are reached. Inevitably, any quota system will create distortions and may induce unnecessary pain. Investors should brace themselves for bumps along the way instead of shying away from participating in this significant journey toward China’s market liberalization. What lies ahead will be well worth the ride. The author is CEO of Greater China andHong Kong, Standard Chartered Bank.