The Times of London says that mainland China’s new sovereign wealth fund (SWF), set up to manage around US$200 billion of its foreign exchange reserves, could already be buying shares and could be fueling the rapid rise of Hong Kong Exchange (0388.HK). HKEX has risen by 140% from around HK$100 in mid-2007 to around HK$240 today. From August 17th, the recent Hang Seng Index low, reached amid fears of US sub-prime contagion, HKEX has risen 122% vs. only 30% for the Hang Seng Index as a whole. If China’s new SWF has been buying, it’s easy to see how HKEX could have risen so far. The Hong Kong government, just over two weeks ago announced that it had added a 5.88% stake in HKEX (see this article for more on Red Cat Journal’s coverage of that purchase). The combined buying by funds managed by the Hong Kong and China governments around the same time is certainly like adding jet fuel to a bonfire.

As for what this news means for the Hong Kong stock market, it could be positive or negative, depending on your time horizon, and making some bold assumptions. Our assumptions: 1) if China’s SWF has been buying in Hong Kong, it has also likely been taking stakes in other companies besides HKEX and 2) it may not be done buying as US$300 billion is a large sum. If you are a short-term investor and our assumption #2 is right, then expect Hong Kong shares to keep rising, and get ready to book more short-term gains. The inflow from mainland China, combined with expectations of a further inflow from China’s decision to allow domestic Chinese investors to buy Hong Kong listed shares, could keep the Hang Seng Index powering upwards.

On the other hand, if you are a value investor or a long-term investor, the possibility that China’s SWF has been buying might be a bad sign. For one thing, recent share prices may have been distorted with an upward bias by the SWF buying. For another, once the buying stops, if other sources of demand don’t step in to replace the SWF buying, supply-demand balance could change dramatically, and in a direction not good for share prices.

At Red Cat Journal, we don’t attempt to forecast stock market prices, especially in the short-term. However, we can say that the possibility that recent gains in Hong Kong have been due to China’s SWF make us more nervous than excited. In addition, if our assumption #2 is wrong, and the SWF is no longer buying, the downside could come sooner rather than later.

For other sobering news, take a look at this article on potential distortions to A share values.