Has China’s market intervention derailed its liberalisation ambitions?

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Over the last 12 months, China has made significant strides in opening up its financial markets to foreigners, implementing a plethora of policies with a clear path to liberalise its capital account. However, Beijing’s recent interventions to halt the substantial slide in the A-share market and rescue onshore retail investors has raised doubts within the international community as to whether China is really ready to apply the free-market model. What Beijing does from here will be critical in re-establishing trust and instilling confidence with investors that China’s financial house is in order. Until there is further assurance that free-market reform is on track, foreign capital may be hesitant to join the liberalisation party.

Given Beijing’s recent heavy-handed response to arrest the sharp plunge in the A-shares market, it is understandable that market observers may question China’s discipline and readiness to accelerate the opening up of its capital account. For many international onlookers, such interventions have not only undermined investors’ confidence in the market, but also raised concerns that the government’s interference is creating moral hazard and fuelling a future market bubble.

To be fair, China is not the only government in recent years to have intervened in capital markets during crises. For example, we saw similar scenarios during the global financial crisis in 2008 when regulators in a number of developed markets issued short-selling bans on banks. In 1998, the Hong Kong government acted to prop up the markets during the Asian financial crisis. And in October 2010, the Japanese central bank intervened in the stock and foreign exchange markets.

Beijing walking a tightrope

No doubt, China will now have to repair its international image. Beijing currently faces the challenge of walking the tightrope to prevent a potential episode of social unrest instigated by millions of discontented onshore investors who feel betrayed by its policies, while maintaining credibility with the international community — a necessary partner in its liberalisation ambitions. Given that social stability is crucial to any chance of a prosperous future for China, one could perhaps understand why Beijing feels the need to take drastic measures to stabilise the market.

The timing of recent events could not have been worse, however. Over the past year, China’s reform progress had converted even some of the more sceptical among the international investment community. Some were even coming around to the view that China A-shares should be added to the MSCI and FTSE Russell Group standard indices. And there was even growing optimism that the International Monetary Fund would decide this November to include the yuan in its Special Drawing Right (SDR) basket, thereby endorsing the currency and spurring the process of currency and capital account liberalisation.

A lot of progress towards a free-market regime

But Beijing’s interference in the market has undermined the confidence of offshore investors, and some are now questioning whether Beijing is ready to implement a disciplined ‘free-market’ regime. This is unfortunate as Beijing has made significant progress on this front over the past 12 months. For example, it introduced the Shanghai-Hong Kong Stock Connect programme to allow foreigners access to the A-share market; accelerated the approval of more Renmimbi Qualified Foreign Institutional Investors (RQFII) quotas to expand foreign market participation; implemented the Mutual Recognition of Funds (MRF) programme between Hong Kong and China to allow investors to buy funds across the border; and promoted the launch of a number of fixed income and equity products to increase the breadth and depth of the market. Beijing even finally came around to clarifying the capital gains tax rules to remove the overhang on A-share investments and eliminated future capital gains tax obligations to attract foreign capital.

 

China rise

Source: BNPP IP, Z-Ben Advisors, January 2015

The deregulation and reform of China’s overall financial system structure has also accelerated over the past 12 months. The much-awaited deposit insurance scheme was introduced in May to facilitate interest-rate deregulation. China recently extended the Shanghai Free Trade Zone to include three others regions: Tianjin, Fujian and Guangdong. Meanwhile, the People’s Bank of China (PBoC) continues to approve more global renminbi clearing centres. And just recently, the central bank announced it will open up the onshore repo market to offshore renminbi clearing and participating banks. The expansion of the repo market should further facilitate renminbi internationalisation by allowing greater two-way flow under the capital account.

 

china graph

*QFII : Qualified Foreign Institutional Investors
Source: BNPP IP Asia, July 2015

 Liberalisation will change the internal status quo

The opening of China’s capital account has broad and deep implications not only for foreign investors, but perhaps even more so for those within China’s borders. Liberalisation implies a change to the status quo and a reshuffling of the balance between the winners and losers. For example, allowing market participants to set interest rates based on demand and supply drivers facilitates more equitable and efficient allocation of capital. Under the old regime, the PBoC had a controlling hand in determining who the winners and losers were – through the fixed interest-rate structure, for example. In general, the key beneficiaries of financial repression historically were state-owned enterprises (SOEs) and banks; and the losers were savers and non-SOE affiliated companies.

Reforms will help China realise its potential

Make no mistake, liberalisation and reform are needed to ensure a socially stable and economically prosperous future for China – and this is well-recognised by Beijing. China appears to have genuine motives to open up its financial market to the world. After all, the country’s reform/rebalancing plans will take many years and come with a large price tag – perhaps even beyond China’s deep pockets. But in return, foreign investors can partake in China’s likely long-term growth. With a population of 1.3 billion and domestic consumption penetration rates significantly below those of most developed markets, the full potential of Chinese consumption has yet to be unleashed.

No doubt, recent events have eroded investors’ confidence. For how long is unclear at this point. What Beijing does from here will be critical if it is to re-establish trust with the international investment community and instil confidence that China’s financial house is in order. Until there is further assurance that free-market reform is on track, foreign capital may be hesitant to join the liberalisation party.

 

Hue Lu

Senior Investment Specialist, Asia Pacific and Greater China equities

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