China economy

China’s more open capital markets will aid its rise as a global financial hub

Thomas Deng says the inclusion of onshore Chinese A-shares by the MSCI global equity index and the start of the Bond Connect will promote foreign ownership of mainland assets, and the resultant inflow of funds will lead the way to liberalisation

PUBLISHED : Wednesday, 12 July, 2017, 11:35am
UPDATED : Wednesday, 12 July, 2017, 6:37pm

After a painful defeat by the Kuomintang in 1934, Mao Zedong ( 毛澤東 ) led the People’s Liberation Army on a series of marches across 9,000km of the Chinese hinterland. The journey would be called the Long March, and Mao’s leadership during the 370-day expedition would endear him to soldiers and civilians alike. Many historians credit the event with the leader’s ascent to power.

More than 80 years later, the Chinese Communist Party is in the midst of a figurative Long March – the opening of its financial system. Albeit less physically strenuous, the systematic transformation of China’s capital markets has the potential to culminate in China’s ascendancy as a global financial powerhouse.

The process began in 1978 and took shape over the following decades; with Deng Xiaoping’s ( 鄧小平 ) reforms in the late 1980s and early 1990s, and China’s admission into the World Trade Organisation in 2001, the notable milestones. Significant progress continues to be made. Two recent achievements, in particular, have underlined the central government’s commitment to this path: the inclusion by index compiler MSCI of onshore Chinese A-shares; and the start of northbound trading on the Bond Connect.

Why China’s MSCI breakthrough is the most important non-event of the year

Renminbi internationalisation is gaining momentum again

However, there is much work to be done if the Communist Party is to attain its lofty financial goals. China’s economy may be the second largest globally, but, according to Swift (the Society for Worldwide Interbank Financial Telecommunication), renminbi usage accounted for only 1.6 per cent of transactions globally in May, making it the seventh most transacted currency, and a minnow compared to the 42.1 per cent market share held by the US dollar. At the same time, US and European stock financial markets are considered far more stable and mature than China’s onshore market.

Still, China’s equity (second largest by total market cap) and bond (third largest) markets are among the biggest globally and are almost entirely funded by domestic investors. Heavy regulation has prevented non-mainland-Chinese investors from owning more than a smidgen of Chinese assets. For example, foreign currency borrowing still accounts for less than 5 per cent of total credit in China’s financial system.

Communist China’s becoming a key player in global capitalism

But this is set to change with the addition of onshore stocks into MSCI’s index family and the latest expansion of the Connect scheme, both of which share the vital goal of enticing foreign ownership of mainland assets. The MSCI inclusion could well trigger US$210 billion in inflows in the next five years, while the Bond Connect could lure around US$250 billion in passive flows over several years, once China is included in the top-three global bond indices (Citi’s World Government Bond Index, the Bloomberg Barclays Global Aggregate Index, and JPMorgan’s Government Bond Index-Emerging Markets).

As the country continues to peel back layers of regulation, China has the potential to rival the US as a global financial hub

Burgeoning fund inflows from abroad have two important long-term implications: first, they would alleviate capital outflow pressure via more robust two-way flows. Chinese investors’ pent-up desire to diversify abroad has resulted in mounting one-way flows out of China, which has dented sentiment and stymied the maturation of the domestic market. Cash coming into China would help to negate the net foreign exchange impact, marking a significant structural shift for China’s financial market.

Second, fund inflows would probably encourage the Chinese government to relax its grip on capital controls and therefore encourage further liberalisation of its financial market. For example, the Bond Connect is currently only available to international investors who want to buy Chinese bonds – not the other way around. The southbound route is expected to open once the central government feels more comfortable about the balance of capital entering and leaving the country.

Bond Connect a one-way street until southbound trade opens

As the country continues to peel back layers of regulation, China has the potential to rival the US as a global financial hub. With increased investment, China’s financial markets can become the world’s largest. In tandem with ongoing efforts like the internationalisation of the renminbi, China’s Long March to a free market should consolidate its leadership in finance, even if not immediately.

Thomas Deng is regional CIO and chief China strategist at UBS Wealth Management