Hong Kong Should Cut Stock-Trading Tax

(Bloomberg Opinion) -- Hong Kong’s stock market is in need of support. While the Hang Seng Index rose the most in more than 10 months Wednesday after Chief Executive Carrie Lam formally withdrew an extradition bill that sparked months of protests, the benchmark remains 5% lower than in mid-June before the turmoil started. The government should consider cutting the trading tax, or stamp duty, on small and mid-cap stocks. That would improve liquidity and raise entrepreneurial spirits during a fragile period.

The city’s trading costs are the highest among major stock exchanges, with stamp duty and transaction fees making trading 35% more expensive than in the U.S. New York and Tokyo have no stamp duty, and there’s only a modest tax in mainland China and London. These costs, combined with liquidity concerns, mean investors focus only on the top 100 stocks, which account for about 70% of the exchange’s HK$80 billion ($10 billion) average daily trading value. The next 200 account for 20% of trading, while the remaining 2,100 stocks are left to squabble over the last 10%. Clearly, the system is top-heavy.

Institutional investors accounted for 84% of trading volume last year, according to the Hong Kong stock exchange, with activity increasingly driven by algorithmic and quantitative methods. Stock pickers buying and selling on fundamentals perform only 10% of trades, research by JPMorgan Chase & Co. suggested in 2017.  As a result, investment strategies are increasingly sensitive to bid/ask spreads and trading costs. In Hong Kong, paying 22 basis points for stamp duty and transaction costs is cutting into investors’ margins and profits, especially when institutional brokerage commissions are as low as 3 basis points.

Cutting stamp duty first on small and mid-cap stocks, as I proposed in 2018 , would help improve liquidity and trading costs for 300 to 400 companies and make them more attractive to retail and institutional investors. If the program is successful, the government could then consider an across-the-board reduction.

My discussions with government officials indicate that they are concerned such a move would reduce revenue and be hard to reverse because of industry resistance. Stamp duty on stocks accounted for roughly 5.5% of government revenue in the past few years. It’s worth noting that Hong Kong’s government is hamstrung by a narrow tax base – there are no levies on sales, capital gains, inheritance, or even beer and wine – so moving ahead would require conviction and determination. 

The targeted tax reduction would aim to have a net-neutral impact. For fiscal 2019-2020, total government revenue from the stock-trading tax is expected to be HK$38 billion. If stamp duty on small and mid-cap stocks were cut by 50% and their trading volume subsequently improves by 30% to 50%, the net impact on government coffers would be only HK$3 billion. Considering the Hong Kong government generated more than HK$600 billion of revenue in fiscal 2017-2018, it has ample room to test new ideas. 

Another important benefit would be to narrow the valuation gap between larger and smaller companies. The MSCI Hong Kong Large Cap index has a 10-year average price-to-book ratio of 1.4 times, versus multiples of 1 for the mid-cap and 1.1 for the small-cap indexes, according to data compiled by Bloomberg. If liquidity improves for smaller stocks, that valuation gap of close to 40% will narrow.

What should be the cutoff point for small and mid-cap stocks? A simple strategy would be to follow the Hang Seng Index classifications. There are 112 stocks in Hang Seng’s large cap index, 193 in the mid-cap gauge and 180 in the small-cap equivalent. Inclusion is market-driven and determined by Hang Seng Indexes Co. This will encourage constituents to do well in order to remain in that index, and companies that strive for inclusion to improve their business performance, corporate governance and investor relations. At the same time, it will allow for the exclusion of so-called shell companies that don’t deserve to benefit from the stamp duty cut.

The government should use this opportunity to enact stock-market policies and stimulation programs that couldn’t be done before. As the saying goes, never let a good crisis go to waste.

Average volume over the past 10 years.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Ronald W. Chan is the founder and CIO of Chartwell Capital in Hong Kong. He is the author of “The Value Investors” and “Behind the Berkshire Hathaway Curtain.”

©2019 Bloomberg L.P.

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