The impacts of the US dollar index and the investors’ expectations on the AH Premium – a macro perspective

This paper aims to provide a macro perspective to explanations of the AH premium, that is, the A and H share price differences of cross-listed companies, particularly the surge of the AH Premium Index after 2015: after the initiation of Shanghai–Hong Kong Stock Connect (SH Connect) in November 2014, the AH Premium Index jumped from 115.8 to 126.4, with a significant decline in its variance. We find that the impacts of US Dollar Index shocks dominated the overall changes in the AH premium on an individual equity basis over 2007–2019. Moreover, the US Dollar Index explains 50%-70% of the changes in the AH Premium Index, and investors’ expectations of the Chinese economy add another 10% to the explanatory power. Segregating the impact of the US Dollar Index, the average AH Premium Index only increased 2.7 percentage points, from 98.8 to 101.5. Further, after the initiation of SH Connect, the prices of cross-listed shares have been more responsive to exchange rate information. Over a longer term, SH Connect may have reduced the impacts of the US Dollar Index and increased the impacts of effective prices on equity prices. These findings demonstrate that hedging foreign exchange risks is the main reason for investment in H shares of mainland firms and, as a result, enhancing RMB foreign exchange rate flexibility is the core component as well as precondition for financial market opening in China. When market conditions permit, policy makers and regulators should consider a pilot program allowing investors to arbitrage the H shares of mainland firms with the AH premium in a reasonable range. This may further reduce the AH premium and enable the share prices to converge in the long run.