On December 29, 2017, the China Securities Regulatory Commission announced that, with the approval of the State Council, it would launch a pilot program for the “full circulation” of H-share listed companies to further optimize the overseas listing and financing environment for domestic enterprises and deepen the reform of the overseas listing system. Following the principles of being proactive, steady, and step-by-step, the pilot will advance in an orderly manner with one company at a time once it is ready, and no more than three pilot companies will be involved.
H-shares refer to foreign shares registered in mainland China but listed in Hong Kong. Under the previous structure for mainland enterprises listing in Hong Kong, shares held by domestic shareholders before listing were called “domestic shares,” while those held by foreign investors were called “foreign shares.” After listing, the H-shares issued by mainland enterprises in the Hong Kong market could circulate freely, and foreign shares could also be converted into tradable H-shares, but “domestic shares” could not be circulated, which artificially created a shareholding segmentation.
However, this restriction does not apply to companies listed on both the A-share and H-share markets. Since A-shares are fully tradable, listed companies can mostly achieve the circulation of their equity directly on the A-share market, reducing the strong demand for the Hong Kong platform.
Additionally, if domestic enterprises list in Hong Kong using the “red-chip model,” which refers to the practice where domestic companies transfer their domestic assets, rights, equity, asset acquisitions, or contractual control (VIE) to an offshore company registered abroad, and then use the offshore company to hold the domestic assets or equity, and subsequently apply for a listing on the Hong Kong Stock Exchange under the name of the offshore company. The shares in this case are fully tradable.
But there are still significant differences between H-shares and red-chip shares. The most important point is that it is easier to establish an A+H platform with H-shares, whereas it is very difficult for red-chip shares to be listed simultaneously on the A-share market.
In other words, the previously non-fully circulating H-shares only affected domestic enterprises listed exclusively in Hong Kong.
Regarding the issue of full circulation of H-shares, the CSRC has always been relatively cautious. After the revision of the new “Company Law,” there are no longer any legal barriers to the full circulation of H-shares. However, whether it is discussions on capital flows or the issue of valuation differences between the two markets, there has been considerable resistance to achieving the goal of full H-share circulation.
According to the current procedures, the conversion of domestic shares into H-shares and their listing and trading on the Hong Kong Stock Exchange require approval from both the CSRC and the Hong Kong Stock Exchange after a resolution by the shareholders’ meeting.
It was not until July 2017 that the People’s Bank of China released the “China Financial Stability Report (2017),” which explicitly mentioned advancing the pilot work for the full circulation of H-shares. This reignited market expectations for the H-share full circulation pilot.
From an external perspective, the H-share full circulation pilot is another major reform in the CSRC’s overseas listing system in recent years.
In the past, the non-full circulation of H-shares had a series of impacts on both investors and listed companies.
First, the domestic shares of H-shares (including those held by major shareholders) could not be reduced, leading to a significant undervaluation of their value. This caused great psychological imbalance among major shareholders and weakened their motivation to implement good corporate governance. The shell value of H-share listed companies with a red-chip structure on the Hong Kong market reached as high as HK$700 million (control premium), but buyers had no interest in H-share shells due to the lack of circulation of domestic shares, losing this benefit and greatly reducing the interest of major shareholders in listing.
Aside from raising funds, major shareholders had neither the option to reduce their holdings nor to pledge their equity. Unless the major shareholders were solely focused on development and indifferent to personal gains and losses, they would lose interest in listing in Hong Kong.
Once the full circulation of H-shares is achieved this time, it will bring positive significance on three levels.
The first is for the shareholders. Full circulation can give the management of listed companies more expectations. As long as performance is good, more shares can be traded in the market, which will motivate management to deliver better results.
Second, after full circulation, listed companies can pledge more shares for financing and refinancing, further improving the liquidity and vitality of the listed companies.
Finally, it ties the interests of management and small shareholders together, providing more protection for small and medium-sized investors.
An analyst at a Chinese-funded securities firm in Hong Kong also said, “After the full circulation of H-shares, major shareholders of mainland enterprises listed in Hong Kong can sell their domestic shares to cash out. At the same time, they will have more motivation to improve company operations and enhance profitability.”
However, there is also controversy over whether giving major shareholders the option to reduce their holdings through full circulation of H-shares will be a negative for the Hong Kong stock market?
According to a report by China Fund News, CSRC spokesperson Chang Depeng pointed out that the full circulation pilot is limited to the reduction and increase of the original shareholders' own H-shares. Relevant shareholders of the pilot companies may initially reduce their holdings of the company's H-shares; after the relevant technical systems are upgraded, the function to increase holdings of the company's H-shares will be enabled.
An analyst at a Chinese-funded securities firm in Hong Kong said, “Currently, the number of pilots is small and will not have a significant impact on the Hong Kong stock market. But in the long run, if full circulation is fully implemented, it will encourage more mainland enterprises to list in Hong Kong, which will boost the trading volume of the Hong Kong stock market.”
However, some Shanghai-Hong Kong-Shenzhen fund managers believe that this move may be difficult to implement in the Hong Kong stock market, which is dominated by institutional investors, and trading volumes at high stock prices may be very low.
In addition to the potential impact on the Hong Kong stock market, some analyses suggest that if H-shares can eventually achieve full circulation, it may pose a serious challenge to the New Third Board.
In the view of Gao Fengyong, founding partner and CEO of Lidings Capital and chairman of Luanhai Capital, historical reasons have made the A-share market the one with the highest valuations and best liquidity globally for traditional industries. The New Third Board can never and does not need to compete with the A-share market in this regard.
The long-term prosperity of the New Third Board lies in using the space left by the strict approval system for A-share listings to cultivate its own emerging industry sectors. These emerging sectors cannot be listed on the A-share market immediately, either due to performance reasons or because of domestic regulatory policies, industrial guidance, and other factors.
For example, it is almost impossible for internet finance to be listed on the A-share market. And under various inconveniences in overseas markets, the third board has the opportunity to allow these emerging enterprises to thrive in the third board market.
If H-shares can achieve full circulation, these emerging enterprises will have more motivation to move toward the Hong Kong Stock Exchange rather than stay on the New Third Board. In this sense, the future development of the New Third Board is worth worrying about.
However, while the full circulation pilot can proceed, achieving full circulation of both existing and incremental shares remains a long and challenging journey.
For A-shares in mainland China, Hong Kong is a region where capital is difficult to regulate. The issuance requirements for H-shares mandate that overseas shareholders be held in custody at a central depository, and non-tradable shares account for a significant proportion of the market's total value.
If all existing shares were made tradable, it would mean that major shareholders could take funds out through cashing out or pledging their equity—essentially a form of disguised capital flight. Striking a balance between ensuring tradability while preventing major shareholders from cashing out or circumventing regulations requires the formulation of practical and enforceable regulations.
There are also legal risks associated with the "one country, two systems" framework. If all H-share domestic shares became fully tradable, it would mean that transactions involving these financial products would be governed by Hong Kong law, while the actual location of the shares remains in mainland China. The differences in laws between the two regions pose a significant challenge in determining the legal principles for handling future disputes.