The impact of the Shanghai–Hong Kong Connect on the market liquidity and price divergence

The economic growth of China has seen an increase in its demand for capital, fueling its local stock markets. This paper exams a market liberalisation event between China and Hong Kong and its impact on: (1) market liquidity and (2) price differentials between cross-listed stocks across the two markets. On November 17, 2014, the Shanghai Stock Exchange and the Hong Kong Stock Exchange introduced the much anticipated, Shanghai-Hong Kong Connect, a bilateral investment channel between the two markets. The new channel brings with it accesses to new capital for domestic firms and trading expertise from new foreign participants. The Shanghai-Hong Kong Connect permits mutual market access for market participants, allowing investors in each market to trade in the other market using existing trading infrastructure. This study adopts a difference-in-difference methodology and finds that market liquidity as proxied by transaction costs, improves in both markets, for eligible stocks that are traded through the bilateral investment channel, post November 17, 2014. This result is consistent with literature, which identifies the benefits of open and enhanced market access. In addition, reported results identify that the pre-existing price premium between cross-listed China A-shares and Hong Kong H-shares, increases following the market design change. Contrary to expectations, this result is attributed to the incremental improvement in liquidity in China for cross-listed stocks vis-à-vis Hong Kong. Overall, results in this study demonstrate that the partial liberalisation of fund flow between the two markets had a positive impact on liquidity, in particular for China’s largest equity market the Shanghai Stock Exchange.