Beijing's Beady Eye Fixes on the Small-Stock Shadows

(Bloomberg Gadfly) -- Hong Kong has seen its fair share of illiquid stocks that soared amid suspicions of manipulation only to collapse, with Hanergy Thin Film Power Group Ltd. perhaps the most notorious recent example. China is anxious to avoid such explosions on its own exchanges.

That's the motivation behind the plan to assign unique identifiers to each investor or firm trading Shanghai or Shenzhen equities from Hong Kong through the Stock Connect program that links exchanges in the two jurisdictions.

Starting in the third quarter of next year, the change will align northbound trading with mainland practice. Chinese regulators and exchanges currently have real-time access to the identity of every investor in the mainland, enabling them to investigate suspicious trades quickly. Authorities in Hong Kong, on the other hand, must request such data from brokers. 

China has reason to be nervous. About 1,900 stocks in Shanghai and Shenzhen are eligible for trading through the connect, compared with only around 500 in Hong Kong. In about 20 percent of the mainland stocks the value of shares traded was less than 30 million yuan ($4.5 million) on Thursday, making them potentially vulnerable to manipulation.

The bar for participating in the connect from Hong Kong is also lower. Anyone with a brokerage account in the city can trade eligible stocks in Shanghai or Shenzhen; mainland-based individual investors must have at least 500,000 yuan in their account to trade through the southbound link.

Several incidents have already rattled regulators in Shenzhen, the more speculative of the two mainland markets. SF Holding Co., known as China's FedEx, surged almost 75 percent in seven trading days in February after its so-called backdoor listing (in which a company takes over another firm that is already publicly traded). At its peak on March 1, SF Holding was trading at 59 times forward earnings -- rich for a logistics company - and closed as the largest company on the Shenzhen exchange. It fell more than 30 percent in the following two months.

Hong Kong investors may have played a role in that mini boom-to-bust. SF Holding was a participating stock on the Shenzhen Hong Kong Connect from its first day, by virtue of the pre-existing listing. Hong Kong Exchanges & Clearing Ltd. sent letters to brokerages demanding trading records on SF Holding, purportedly at the request of the Shenzhen exchange, the Standard reported.

Foreign investors bought a net 35 million yuan of SF Holding shares via the trading platform on Feb. 27, and a further 70 million yuan on March 1. SF Holding's free float, or the number of shares freely available to be traded, is only 4.9 percent of the total. Hong Kong rules mandate a free float of at least 25 percent; stocks that have a small float and are thinly traded can be manipulated more easily.

In March, the China Securities Regulatory Commission fined Tang Hanbo, a Chinese citizen based in Shenzhen, for using the northbound connect from Hong Kong to manipulate shares of Shenzhen-listed Zhejiang China Commodities City Group Co., a mid-cap company with $1.4 billion of revenue last year.

Stability is the priority. As China prepares for the nation's yuan-denominated A shares to join MSCI's global indices next summer, the government wants a slow-moving bull market.

The state-owned Xinhua News Agency derailed a rally in Kweichow Moutai Co. last month with an editorial warning on risks after the liquor maker's stock more than doubled this year. The China Securities Regulatory Commission, meanwhile, has toughened its IPO review process, rejecting all three applications on Wednesday. The approval rate is running at less than 60 percent, versus 81 percent in the first three quarters, Xinhua said

Regulators may have a problem with overpriced blue chips, but they also need to keep an eye on smaller companies. Of the 944 stocks on the Shenzhen Connect, 20 percent trade on at least 68 times reported earnings.

This pervasive investor surveillance isn't going away.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

Shuli Ren is a Bloomberg Gadfly columnist covering Asian markets. She previously wrote on markets for Barron's, following a career as an investment banker, and is a CFA charterholder.

To contact the author of this story: Shuli Ren in Hong Kong at sren38@bloomberg.net.

To contact the editor responsible for this story: Matthew Brooker at mbrooker1@bloomberg.net.

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