The ties between China and America are the worst they have been in decades, and there is little reason to think they can improve in the near future, yet amongst all the gloom there have been a series of slow, although not always steady, developments which have opened up parts of China’s financial markets to unprecedented levels. Forty years after the first share issuance in modern China, and nearly 30 years after the establishment of the Shanghai and Shenzhen stock exchanges Chinese capital markets have never been as open as they are now. A cynic may say that is always true as China painfully inched its way forward with financial reform and embrace of foreign capital flows. But this time really is different. China has reached a level of openness which will require foreign investors to reevaluate what their Chinese domestic and international strategy is. The openness encompasses both portfolio investment in broad capital markets as well as foreign companies as financial intermediaries across brokerage, banking and insurance sectors.
The international investor community find themselves in an almost absurd position. As discussed last month in grici.or.jp/587, there are meaningful steps starting to be taken within the US Congress to target US capital flows into Chinese companies and markets. Possible development of that Capital War need not be addressed further but investors are simultaneously being asked to plan out longer term investment strategies in China but also consider the need for a fast and possibly comprehensive withdrawal from Chinese stocks.
If America, Japan, or the EU, or any other country is to meaningful respond to the challenges that China poses it is important that a realistic and honest appraisal is needed of what China is doing right and what it’s doing wrong. China’s financial openness is far from complete and at times the openness on the surface doesn’t capture the cumbersome processes that investors need to follow.
To understand where China is today it is important to look back at how China has traditionally restricted investors. The first approach has always to keep foreign and domestic investors in a market at arm’s length. There was a market for locals and another one for foreigners. In the stockmarket this developed as the A share market for locals and the B share market for foreigners. Two distinct pools of capital which in all practical sense did not mix. Taking that a step further as Chinese companies needed foreign capital, because their own domestic market was too small, overseas listings in Hong Kong and New York became the solution. For years some of the largest domestic Chinese companies were off limits to the Beijing man in the street yet fully accessible to investors from Tokyo to Topeka.
China’s economic rise ensured that its onshore and offshore markets flourished and grew but independently with different companies and sectors being represented. In the case of the bond markets there was no offshore market. China issued very little government debt internationally in contrast to the ballooning issuance onshore. In 2003 Chinese authorities started to address the growing interest in their domestic markets with the introduction of the Qualified Foreign Institutional Investor program. This captured exactly how China would restrict foreign participation. Firstly, there was a high qualification hurdle, only the largest global firms could meet requirements in terms of size, status and longevity. Then there was specific limits or quotas on how much could be invested. Each step of the way required long application processes and approvals which could take months. Requests for increase investment quota could take years for approval. That coupled with incomplete tax rules and implementation, meant repatriation of profits required a wait of many years. These brief words only scratch at the cumbersomeness of the processes. Equity markets at least had a procedure. Bond markets by contrast were just off limits to foreign portfolio flows.
For the financial intermediaries the restrictions basically ruled out complete or majority ownership. Foreign firms were forced to go in via joint ventures with stakes as low as 20% and perhaps rising to 49% but majority control was not allowed.
The financial sector has long been an area in need of reform. China has paid lip service to those needs and while understanding the importance of better capital markets to allocate capital there has been a continual reluctance to step back from heavy handed interference in the marketplace. The changes that did happen were painfully slow yet about 5 years ago the dynamic changed. For equity investment the introduction of China Connect via the Hong Kong Exchanges did away with any sort of approval to invest. It changed how money could come in and out of the country. Repatriation and tax rules became clear which allowed the QFII scheme to grow to the point that, in new rules announced this year, will effectively put foreign and local investors on a level playing field in terms of market and product access.
Bond investment received a shot to the arm when the PBOC announced it would fully open the interbank bond market to foreign institutions allowing funds to flow freely in and out of the country and eventually allowing the use of onshore FX hedging tools to mitigate currency risks. To further bolster bond access, the HKEX in 2017 launched Bond Connect which followed a similar model as the equity access route of using HKEX infrastructure to buy and sell on the domestic markets.
JPMorgan and Nomura have both become majority shareholders in their onshore brokerage firms and while the banking sector sees foreign banks hugely underrepresented this is perhaps less surprising given the rise in bad loans and the huge established positions of the major Chinese banks.
For an institutional investor of any significance full access to equity and bonds market is already available in large part. Those same investors are also finding it easier and quicker to set up onshore vehicles as well to raise and manage domestic funds. It seems contradictory with the elevated rhetoric of the trade war that financial markets are so open, remain so open and more significantly look set to keep opening.
Looking solely at portfolio flows the combined impact of the opening is not insignificant. Foreign holdings of Chinese bonds total around 240 bn USD, China Connect inflows are 100 bn USD, QFII lags slightly with an estimate 90bn USD. Foreign holdings of offshore Chinese assets such as HK and NY listings and offshore bonds are also significant but the above three programs show well over 400 bn USD of assets now in Chinese domestic securities. Those numbers are set to grow as the market openness means Chinese A shares and bonds become part of global indices which are then tracked by fund managers so a natural flow of passive funds will need to be allocated to Chinese securities. For those who dismissed China as closed off and too difficult to invest in there is nearly half a trillion USD of investments which show otherwise.
The openness is impressive when compared to the situation of a decade or two decades ago, but foreign participation remains low in percentage terms. These large numbers still only account for low single digit holdings of Chinese securities. Significantly lower than would be expected given China’s global economic footprint and significantly less than say a market like India where foreign holdings are around 20% of the market.
China’s opening of its markets has been too slow, and the percentage numbers show it but at last the Chinese authorities have gotten foreign investors and intermediaries to the starting gate. It has been late in coming but the facilities and investment avenues now at least give foreign firms a chance to properly plan a domestic investment strategy. What was it that changed? Why now? But really the question is why so long? The rationale and need for opening have long been understood by those at the top but domestic political concerns and fear of losing control to foreigners has long been a concern. The lessons of the 1997 Asian Financial Crisis cast a long shadow in China. The simplistic example of a foreign fund manager presses a button in New York and one billion USD leaves Thailand would have given Chinese regulators many a sleepless night. They now realize that with the increase in size of their markets and the correct structure of investment channel to monitor and oversee foreign investment then foreign flows need not become a free for all.
The meaningful opening reflects several things. Firstly, China is now confident enough that it feels its market and local firms can withstand the competition which opening brings. As mentioned, that they now can monitor flows gives tremendous comfort in a market which has shown time and again how prone it is to bubble and bust cycles. Secondly it reflects the real benefits that opening brings to China. There is substantial demand for China exposure from overseas investors. The onshore markets are growing with hundreds of listings every year while most overseas markets are stagnant or decreasing in the number of listings. Allowing in foreign capital integrates China into global flows and brings in money at a time when the economy is seriously weakening, and the risk of capital outflow remain high especially in times of shock.
It would be wrong to think that China is now on opening autopilot. There are many aspects of the domestic markets which can be improved and streamlined from an operational perspective and even more importantly the quality of listing companies and financial disclosure is generally seen as woeful. From the largest banks underreporting NPL rates to private companies just making up fictious bank balances there are lots of reasons to be wary of Chinese companies. But that is exactly why so many fund managers are excited about China. Finding the good companies and good businesses hidden amongst the bad makes it an ideal stock pickers market. Daily liquidity is very high, often higher than the rest of all the other Asian markets combined, and the market allows short term traders ample opportunity to chase trends. The regulators and their political overlords remain too focused on trying to direct outcomes and should be expected to continue to insert themselves into market life for many years to come but investors both domestically and internationally realize that this is part and parcel of business in China. Understanding that the rules of the game are different in China does mean expectations need to be held in check, but is doesn’t mean that there are not opportunities to make money for investors nor does it mean there are not compelling investment stories out there.
Does such a large financial engagement mean that the Capital War drive will eventually peter out? That is far from clear as the moves proposed so far from Senator Rubio and others are very targeted, but it does mean that there will be significant pushback from the institutional community who have already made a huge investment into China and want to continue. China is, and will remain for some time, the world’s second largest economy, it’s capital markets and bond markets rank amongst the largest in the world. There will continue to be many opportunities for foreign financial houses in the coming years. After so many years of frustration foreign firms need to be realistic about what can be achieved and how they should engage but firms will not willingly leave China. The decoupling of the US and China is real. That broad trend will continue for many years to come but not all industries will be affected in the same way. China may become less important in the global manufacturing chain, but all indications are it will, on its current path, become more important in the capital flows. After decades of lobbying to allow greater access to Chinese domestic capital markets foreigners are seizing the opportunities just at a time when that long sought engagement is being tested more than ever.
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