The latest rush by Hong Kong-listed mainland enterprises to seek yuan-denominated A share listings in Shanghai is putting forward a strong case for linking the two markets.

This idea has been floating around Hong Kong for quite some time. It's received wide support from the government as well as the financial community. Recognizing that unification of the two exchanges is an impossibility at this time, financial experts are focusing on ways to create a channel for trading dually listed mainland shares in both markets.

Such a channel would help remove the inherent anomalies in the existing dual-listing arrangement. It would pave the way for the creation of a market big enough to become an efficient and reliable financial intermediary that can meet the projected capital needs of China's economic development.

In one of his essays, Joseph Yam, chief executive of the Hong Kong Monetary Authority, the de facto central bank, wrote: "It would be in the interests of the country to create a channel between the financial markets of the mainland and Hong Kong to allow them to function as one, much larger market with greater liquidity, more efficient price discovery, and better market discipline and risk management."

For historical and other reasons, a range of basically the same financial instruments are traded in the stock markets on the mainland and in Hong Kong. For example, a growing number of mainland companies' shares are traded as H shares in Hong Kong and A shares on the mainland.

They are essentially the same instruments although traded in different currencies and subject to different supervisory and regulatory requirements. Holders of these two different classes of shares usually enjoy the same voting and other rights. But there is no mechanism of arbitrage under the present regulatory framework to efficiently equalize the prices of the same companies' shares traded in the two different markets.

Any attempt to link the two markets will have to be initiated by the authorities on the mainland and in Hong Kong. This is because it would touch on the issues of currency convertibility, especially in the capital account, and restrictions imposed by the mainland on the mobility of users and providers of financial services, and of capital and financial instruments between the two jurisdictions.

Despite these hurdles, it is feasible to link the financial infrastructures of the two systems, including payment, settlement, clearing and custodian mechanisms by a channel with a high degree of controllability. There have been a number of suggestions on how such a channel could be built.

One recommendation from Yam is to synchronize, in the approval process, the Qualified Foreign Institutional Investor and the Qualified Domestic Institutional Investor schemes to bring about a zero net inflow and outflow of funds, or, if necessary, to allow a net flow in either direction to achieve a better balance of international payments.

Another method that has been widely discussed is to create derivative instruments, such as certificates of ownership of shares listed on the Shanghai, Shenzhen and Hong Kong stock exchanges. They would be traded in the two markets with an arbitrage mechanism to equalize prices.

Designing an effective channel to link the mainland and Hong Kong markets would invariably involve a host of policy issues. But the advantage of having a big, active and efficient capital market must seem obvious to economic planners on the mainland and in Hong Kong.

E-mail: jamesleung@chinadaily.com.cn

(China Daily 02/13/2007 page10)