Hong Kong’s China-fuelled rally is at Beijing’s mercy

Hong Kong shares have been among the world’s best performers this year, but concern is mounting that China could take away the punch bowl.The Hang Seng Index fell as much as 1.2% yesterday after China was said to have stopped approving mutual funds that plan to invest mainly in Hong Kong stocks. Mainland investors have been a major force behind the market’s surge, with their net inflows totalling $86bn from April 2016 through last month, data compiled by Bloomberg show, compared with just $3.3bn from foreign funds based elsewhere, according to EPFR Global data.With these rising Chinese inflows come the risk of a reversal, especially given the nation’s notoriously fickle regulations and market conditions. The question now is whether the latest move signals China’s policy makers are growing uncomfortable with the large flows into the Hong Kong equity market, which has posted gains five times Shanghai’s this year.“If money keeps going south to Hong Kong, then for a closed-end system such as the Chinese A-share market, it will present a liquidity drainage,” said Hao Hong, chief strategist at Bocom International Holdings Co in Hong Kong, referring to mainland shares. “Now that they have a policy stance to slow down the flows, and Hong Kong is coming near the 30,000 resistance, you may see money slowing down.”The Hang Seng ended on Monday at 29,681 points, less than a week after it closed above 30,000 points for the first time since 2007. Hong Kong’s market has become increasingly tethered to mainland China’s in recent years, after an exchange link began in late 2014.For Chinese buyers, Hong Kong shares offer a unique proposition: the chance to diversify portfolios beyond the confines of the Shanghai and Shenzhen markets, even as Beijing keeps a tight rein on capital controls. Improving earnings at Hong Kong-listed companies and valuations that are cheaper than the mainland are the icing on the cake.Yet inflows to Hong Kong may have swelled beyond the comfort zone of China’s regulators, which are known to intervene haphazardly in the nation’s financial markets. Yesterday, Chinese media reported without attribution that some public funds have been told not to sell stocks on a large scale, after the Shanghai benchmark fell to a three-month low on Monday.The government may be restricting new Chinese funds that buy Hong Kong shares because demand has been especially frenzied lately, said Thomas Kwan, chief investment officer at Harvest Global Investments in Hong Kong. Still, the effect will be mitigated by the fact that existing funds and wealthy individual investors remain unchecked, he added.Overseas investors have been less enthusiastic about Hong Kong.Global active mandates are underweight by about 300 basis points on offshore Chinese stocks, Goldman Sachs Group Inc estimates. But there are now early signs Asia ex-Japan funds are raising their allocations in Hong Kong and China, the US bank said. “Given the relatively healthy fundamental backdrop that we’re expecting for China in 2018 and still reasonable valuations in terms of the gap between China and developed markets and emerging markets, we do expect some further rise in allocations to take place from global active mandates in Hong Kong and China,” Kinger Lau, Goldman’s chief China strategist, said at a briefing last week.