Illustration: Xia Qing/GT

A recent research paper written by employees of China's central bank - a macro analysis of China's A share and H share price differences in cross-listed companies (AH premium) - noted that improving the convertibility of capital items and the flexibility of the yuan is the premise and core content of the further opening-up of China's capital market. Based on Anbound's analysis, that is also conducive to Hong Kong's economic recovery and structural reform, so as to avoid the hollowing-out of the city's economy.

China's central bank, the People's Bank of China (PBC), has recently been conducting research and discussions on policies and market changes, an experimental signal for potential new policies. Compared to the PBC officials' statements, public academic papers could be more moderate, allowing markets to be less sensitive to policy changes. 

The yuan exchange rate mechanism and capital flow control are long-standing problems in the capital markets of the Chinese mainland and the Hong Kong Special Administrative Region. Although a unique collaboration between the Hong Kong, Shanghai and Shenzhen stock exchanges has improved their connection, the capital markets still see differences in valuation among investors, as well as differences in market prices. 

According to the paper, markets and policy makers have been wondering why many cross-listed companies' share prices in mainland stock markets are higher or much higher than those in Hong Kong stock markets, and why an enhanced connection between Hong Kong stock markets and mainland stock markets since 2014 has not led to a narrowed AH premium but a systematic surge.

The research revealed macro factors play an important role in explaining the AH premium. The Chinese stock markets' connection has improved the price discovery function of the A-share market and reduced the impact of the US dollar exchange rate on Chinese mainland and Hong Kong stock markets.

Based on Anbound's observations, the yuan's exchange rate saw rapid change during the China-US trade war, which not only affected the AH premium but also China's mainland and Hong Kong stock markets. Therefore, reforming the yuan's exchange rate mechanism to make it more stable and transparent is in line with the benign long-term development of China's stock markets.

The PBC paper noted that hedging currency risk is the main reason to invest in H-shares. Investors focus not only on issuers' future cash flows, but also on currency risks and the future of the Chinese economy. If the A-share market further opens up with more internationalized standards, the AH premium will narrowed. And based on a more mature A-share market, an AH premium level between 5 percent and 10 percent could be allowed to be arbitraged between markets so as to promote price convergence.

Against the backdrop of a potential financial "decoupling" between China and the US, the paper could also offer a review from the perspective of public policies. Since Hong Kong's status has been threatened by the US, promoting the reform of the yuan's exchange rate could practically maintain activity in Hong Kong's financial market and uphold the city's role as an international financial center. 

Reforming the exchange rate system does not mean full liberalization in the short term. The reform should be promoted through the expansion of capital channels, gradually widening markets' connections to narrow price differences and maintain the bulwark between Hong Kong and the Chinese mainland so as to avoid excessive shocks to the mainland from international capital.

The reform of the exchange rate mechanism is actually a single move that affects the whole situation, since the exchange rate plays an anchoring role in China's economic recovery and stability, as well as in the opening and development of its capital market. 

For Hong Kong's economy, the implications are equally important. The fluctuation of the yuan's exchange rate also reflects the potential risks to Hong Kong's economy in terms of foreign trade. Analysis shows that, statistically, Hong Kong's economy is now heavily dependent on import businesses from the Chinese mainland that operate in the city. 

When import businesses decline due to the yuan's depreciation, however, that does not boost Hong Kong's other trade sectors. Instead, the yuan's depreciation leads to a reduction in Hong Kong's total foreign trade volume, and could even lead to recession in all economic activities. Therefore, reforming the yuan's exchange rate mechanism and gradually loosening capital flows are not only beneficial to the opening-up of the Chinese mainland and the outflow of Chinese capital, but are also of great significance to Hong Kong's real economy.

The article was compiled based on a report by Beijing-based private strategic think tank Anbound. bizopinion@globaltimes.com.cn