Chinese Stocks Outperform as Foreign Money Pours In

China has announced it will finally open its equity markets to foreign investors. A trading link will be established between Shanghai and Hong Kong this coming Monday. This will open up access to nearly $2 trillion worth of Chinese equities. The unshackling of China's capital markets marks the largest capital account opening since WWII.

As you would expect, Chinese stocks are reacting very positively to the news as a whole array of new buyers materializes. The Shanghai exchange, which has been anticipating this move since Beijing confirmed launch of the plan seven months ago, has risen to new highs. Year-to-date the Shanghai Composite is up over 17%, outperforming nearly all other international markets as investors have bid up stocks in anticipation of the event.

An event like this has never taken place during my tenure as a market analyst, so I have little idea what to expect. Apparently Chinese regulators feel similarly in the dark as they are taking many precautions to open the doors slowly, wary of potentially destabilizing effects. There will be trading restrictions in place including daily and maximum investment caps, as well as a one-day delay between the time an investor places an order for a Chinese security and when it is executed.

It is widely expected that pending a successful opening of the Shanghai exchange, the Shenzhen Stock Exchange could follow. If this were to happen, the combined Chinese exchanges would represent the largest equity market outside the US.

There's a good chance investors will maintain caution as the transition occurs. Accounting standards are opaque in China, causing concern over the accuracy of financial statements. There is also a big question mark surrounding whether international investors will be required to pay capital gains tax in China. Hong Kong does not levy a capital gains tax, but China does. However, China's capital gains tax of 10% has not been collected from any foreign investors who have purchased assets through qualified institutional investor programs, which have allowed limited access to Chinese assets since 2003.

The above content was an excerpt of Richard Russell's Dow Theory Letters. To receive their daily updates and research, click here to subscribe.

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