China's Financial Market: Positive Reforms

China's latest decision in introducing derivative stock-index futures, short-selling and margin financing in equities are additional positive reforms designed to bring its markets in-line with other major global stockmarkets. Could this be also a further sign that China's financial markets are growing in maturity?

Personally, this is definitely setting the path to the right direction as China continues its effort to liberalize its markets, in order to become more competitive. However, in the short term, it may come at a cost to local Chinese investors as they require time to familiarize themselves with more sophisticated instruments. The degree of learning curve will definitely affect the outcome and return on investments too. For instance, margin financing may sound attractive to many people, in the form of easy availability of funds but if it's not managed properly and effectively, investors may find themselves landing in a bigger financial hole than they could ever imagine.

See related post "Is Margin Trading Right For You?"

Nevertheless, it is widely expected that the above reforms should help shrink the valuation gap that has kept yuan-denominated shares (A-shares) at a premium to similar shares listed in Hong Kong (H-shares) and Singapore (S-chips). The valuation gap between Hong Kong and China, for instance, could trade more than 50% such as what happened in August 2009.
The valuation gap between the two is often attributed to China's capital-account restrictions, which make it hard for average investors to buy shares in foreign markets.

With the availability of shorting mechanism, it will then be possible for qualified Foreign Institutional Investors to short the more expensive A-Share and buy cheaper H-share companies.

Short-selling refers to selling a particular stock first with the aim of buying back at a lower price later, for a profit.

HSBC have estimated the reforms will boost the amount of cash circulated on China's yuan-denominated stock markets by 200 billion yuan (US$29 billion) to 500 billion yuan during the next 12 to 24 months.

It will also be interesting to see if the H-shares will outperform Chinese stocks in the near future, once the above instruments were implemented.

With some believing that the introduction of index futures will help moderate share-price volatility, personally I have doubts that this will happen. Volatility will stay as long as there are abundance of liquidity in the market.

Nevertheless, one could certainly use index futures to hedge against stock holding risk, by shorting index future while being long on stocks.