Deep Dive: Hong Kong Exchanges & Clearing (388 HK)
Hong Kong's monopoly bourse still has increasing strategic role to play
Hong Kong Exchanges and Clearing (HKEX) is the monopoly stocks and derivatives exchange operator in Hong Kong. It’s the largest exchange operator by market cap in Asia, and the fourth largest globally. Quality-focused investors would know that exchanges are outstanding businesses that have mostly delivered strong long-term returns for shareholders over time (HKEX has compounded at ~22% CAGR since 2000).
HKEX can be regarded as a single holding that can provide a broad, top-of-the-funnel China exposure (and a modest dividend yield) - this includes a growing coverage of China’s new economy/tech companies and increasingly the A-shares market through the Stock Connect.
Historically, the prosperity of HKEX was assured by Hong Kong’s undisputed positioning and reputation as one of the world’s premier financial hubs. However, with the city’s crumbling reputation in recent years and narratives focused on its decline, compromised status, and geopolitical risks - one may reasonably ask what is the future for HKEX. We thought this is a good time to dig deeper. It turns out, interesting and unique insights can be derived by looking at the city’s most vital financial infrastructure.
Since 2017, HKEX’s net profit and share price is up more than 100% and 80% respectively despite the progress of the ‘new cold era’ between US and China. And despite the geopolitical decoupling narrative that’s gotten popular, that is not what we see from the vantage of the exchange business. There is tendency to sensationalize the challenges and risks facing Hong Kong, while brushing aside the strategic role Hong Kong continues to play and its resiliency. Our key message here is that it is difficult to derail the Hong Kong story – much more so than most observers would think.
The objective of this report is to try to cut through the noise to separate narratives from reality, and to provide an objective picture on the opportunities and risks surrounding the business of HKEX, as well as on Hong Kong more broadly. Quality-focused investors, and anyone with a general interest in Hong Kong’s state of affairs will likely find value here.
Table of Contents
Intro: Hong Kong’s history, role, and significance
Background of the city’s development and the Hong Kong dollar
Hong Kong’s unique positioning today
Examining narratives versus reality
Decoupling narrative and capital flows
Hong Kong’s relevancy as the China gateway
Hong Kong Exchanges and Clearing (HKEX)
Business overview
Management
Key growth drivers
Listings – current environment and opportunities
Connect Schemes – a deeper look at MSCI index inclusion and other drivers
New products – A50 futures and long-term options in RMB products and on-shore commodities
The LME debacle
Investment income optionality and exposure to rising rates
Risks and valuation
HKD and rates risk
Broader geopolitical risks
Peer valuation and justifying HKEX’s premium
Return expectations and bottom line
Intro: Hong Kong’s history, role, and significance.
From the time Hong Kong was ceded to British rule in 1842, it has enjoyed a unique role as the gateway between the East and the West. However, it was really starting in the late 1970’s, with Deng Xiaoping’s landmark economic reforms, that marked the start of a much more significant era for Hong Kong through deeper economic ties with the People’s Republic of China (“China” or “PRC” from herein).
On the back of physical goods trade leveraging China’s low cost labor and Hong Kong’s capital and ports infrastructure, flow of goods between the border skyrocketed in the 1980’s. China became the world’s factory, and with that Hong Kong also became the world’s busiest container port (at its peak in the early 1990’s Hong Kong’s GDP reached a quarter of China’s). But eventually, Hong Kong’s dominance in goods trade began to diminish as China constructed its own port infrastructure to trade directly with the world. This trend accelerated following China’s ascension into the WTO in 2001.
Adapting to this, Hong Kong embarked on a rapid transition into a services-oriented economy, turning itself into the leading provider of offshore financial services to the growing China. Ever since China’s economic opening in the late 1970’s, Hong Kong has played an important role every step of the way. It had to be nimble, adapting to changing circumstances. But historically one thing remained constant - as China gradually opened up to the world, Hong Kong stood to be a key beneficiary.
With Deng Xiaoping’s economic reform in 1978, the Hong Kong economy experienced an unprecedented boom. This set off a period of soaring inflation in the 80’s which led to rapidly weakening HK dollar. On top of this, the meeting between Deng Xiaoping and Margaret Thatcher in 1982 to discuss the eventual handover of Hong Kong resulted in ballooning pessimism for Hong Kong’s future (the “1997 problem”).
Hong Kong’s stock market, real estate, and currency all tumbled, triggering a vicious capital flights cycle. The HK dollar went on a free fall, declining almost 50% against the US dollar in just one year. In 1983, to save the freefalling currency, HKD was pegged to USD at a rate of $7.8 HKD per USD. Today, Hong Kong employs a currency board system (known as the Linked Exchange Rate System or LERS) which manages the exchange rate in the range between $7.75 to $7.85 HKD per USD.
Under the ‘One Country Two Systems’ framework, Hong Kong enjoys a distinct system from the PRC. Most notably, Hong Kong enjoys an open capital account with a freely convertible currency. Hong Kong also retained its common law legal system, which aligns it closely with other global financial centers such as London and Singapore. Through Hong Kong, international institutions are able to invest and do business with China while continuing to operate under a familiar regulatory framework as they do in their home jurisdictions. For example, as we will discuss later, this is a big reason behind the success of HKEX’s Stock Connect scheme which allows offshore investors to seamlessly own Chinese A-shares.
As a financial center, Hong Kong is the most important foreign currency raising center for PRC entities. The Connect schemes (Stock and Bonds) have also become the fastest growing access channels for foreign investors to invest in on-shore securities. Hong Kong is also the leading offshore RMB hub, with the largest pool of offshore RMB funds (~800bn or roughly half of global offshore total), and has a long-term goal to develop a deeper suite of RMB financial products and services to support a greater global role for the RMB.
For years now pundits have been calling for Hong Kong’s reduced relevance, but as we’ll argue, the reality is that Hong Kong’s strategic role continues to grow. When all is said and done, we believe Hong Kong’s value proposition remains strong despite popular calls on its demise and decline. And in turn, HKEX will continue to benefit from multiple growth channels vis-à-vis Hong Kong’s unique and strategic positioning.
Narratives versus reality
Decoupling and capital flows