Reform pledges likely to hurt both stock prices and yuan
Beijing's liberalisation policies are likely to mainly hit the mainland's state-owned firms, with private-sector competition eroding margins
After suffering initial disappointment, China-gazers everywhere were greatly cheered by the reform plans that finally emerged from the Communist Party's economic head-banging session earlier this month.
Analysts hailed Beijing's agenda for its boldness, and commended the leadership for its emphasis on allowing market forces freer play and for promising to press ahead with financial liberalisation.
The new policies, they agreed, should save China from a painful hard landing, while laying the foundations for sustainable growth in the future.
This upbeat response has been reflected in the financial markets. Since the publication of detailed reform plans, the principal index of Hong Kong-listed mainland stocks has shot up by almost 9 per cent.
Perhaps most impressively, shares of big mainland banks, which have long been shunned by international investors, have typically climbed by between 6 and 7 per cent on hopes for renewed financial sector reform.
Many market analysts expect further gains. Strategists at Goldman Sachs, for example, last week upgraded China's market to "overweight". They especially recommended Chinese bank stocks as likely to see "asymmetric upside risk" from financial liberalisation.
It's too early to tell for sure, but it is likely renewed investor enthusiasm will also attract fresh flows of capital into yuan-denominated assets, in both the onshore and offshore markets.
Certainly in the run-up to Beijing's policy meeting, the mainland saw hefty capital inflows in anticipation of reform, with an estimated hot money influx of around US$40 billion in October alone; up from a net flow of zero the month before.
Meanwhile in Hong Kong's offshore market the volume of yuan deposits shot up by 20 billion yuan in October to a record 730 billion yuan.
Yet despite the prevailing positive sentiment, investors hoping that renewed reform momentum will propel either mainland stocks or the yuan higher in the medium term are likely to face disappointment.
As in any reform process, Beijing's liberalisation plans will create losers as well as winners. In this case the losers will come disproportionately from among China's state sector companies, which make up the bulk of the mainland's stock market capitalisation.
If the promised reforms are pushed through, privileged state-owned companies will find themselves hard-pressed on two fronts, as increased private sector competition erodes their margins, while interest rate liberalisation pushes up their borrowing costs.
As a result earnings are likely to suffer, weighing on stock market performance.
The squeeze is likely to be especially harsh in China's banking sector, where the combination of thinner net interest margins and tighter monetary conditions will depress bank returns on equity.
In the meantime it is far from certain that Beijing's reform agenda will further boost the yuan's exchange rate, as many investors expect.
China currently accounts for almost a quarter of the world's annual savings, more than the United States, Japan and Germany combined. That means if Beijing goes ahead with its pledge to relax China's capital controls, outflows are likely to far exceed inflows, putting heavy downward pressure on the yuan.
The authorities may welcome that pressure. In recent years the yuan's appreciation has helped push China's labour costs sharply higher.
From just half Thailand's manufacturing costs 10 years ago, China's unit labour costs have now reached a comparable level. Yuan weakness would restore some of that lost competitiveness, cushioning the painful impact of Beijing's domestic reforms.
As a result, for investors, Beijing's new-found commitment to economic reform is unlikely to prove the money-spinning proposition they want to believe.