Victim of success

One cannot help shake the feeling that China is sometimes a victim of its own success. Since opening up to the world from the 1970s, it has lifted millions out of poverty, delivered eye-popping levels of productivity growth, and transformed its labour base, coaxing it off the land and onto the factory floor.

So, when Beijing now rolls out a grand plan or simply announces an open-ended intention to deliver something new, investors from Seoul to Singapore to Sydney regard the edict as a fait accompli. Then, when reforms stall or are slow in coming, China’s leaders are derided as timid, their commitment to change called into question.

Nowhere is this impatience more immediately visible than in the financial sector. Over the past decade, Beijing has expanded the international use of its currency, the renminbi, loosened (but not eliminated) constraints on capital inflows and outflows, and begun the drawn-out move to a more flexible and market-determined exchange rate.

Recent developments in the equity markets include the Shanghai-Hong Kong Stock Connect, a scheme connecting the two cities’ main bourses. Launched with much fanfare in November 2014, it is finally starting to attract global institutional investors. Capital-hungry private firms are being encouraged to list on the National Equities Exchange and Quotations (NEEQ), where trading takes place on an over-the-counter basis.

In one week in April, 223 new firms joined the Beijing bourse, pushing the number of listed firms to 6,806, up from 356 at the start of 2013, and six times the number of A-share firms floated on the Shanghai Stock Exchange. The same month, China’s insurance regulator, the CIRC, issued rules allowing insurers to sell shares on the upstart exchange.

Two other major changes to the financial rules that govern how China is run – and how it is seen by the wider world – have been promulgated in recent months.

The first involves China’s currency. When the International Monetary Fund decided in November 2015 to include the renminbi in its basket of special drawing rights (SDR), a group of elite reserve currencies, it came as a surprise to many. The decision means that, as of October 1 2016, the renminbi will become, in the eyes and parlance of the IMF, a “freely usable” currency – terminology widely open to dispute.

An expanded SDR will still be dominated by the US dollar and the euro (which together will comprise 72.66% of the basket). But the renminbi will make up just shy of 11% of the overall weighting, ahead of the other occupants – yen and sterling.

The other major change involves China’s vast and unruly bond markets. Debt is a serious and rising issue, with the level of onshore corporate debt standing at 150% of gross domestic product at end-2015. Beijing has in recent quarters seemed torn between either pursuing a strategy of controlled deleveraging or tacitly pursuing even greater credit growth in order to prop up a sluggish economy, with the latter argument appearing to win out.

“Deleveraging rhetoric has given way to renewed credit expansion in support of growth,” said UBS’s head of China economic research, Tao Wang, in an April 12 report.

The government’s 2016 credit growth target, she warned, implied the creation of Rmb23trn (US$3.5trn) in net new credit this year, up from Rmb18trn in 2015, pushing the country’s debt-to-GDP ratio to more than 300% before 2020.

Rising leverage rates will not, Tao added, ineluctably lead to China’s own ‘Minsky moment’, wherein a liquidity crunch causes a sudden collapse of asset values. That sort of crisis, while a possibility, “could still be years away”.

The bigger near-term concern is a sudden uptick in corporate defaults: more domestic firms missed bond repayments in the first four months of 2016 than in the whole of 2015. In an April 29 research note, Chang Liu, China economist at Capital Economics, warned that rising defaults had “spooked investors” and “introduced a new source of uncertainty into bond markets”.

Situation addressed

All of which makes the People’s Bank of China’s decision in February to permit a raft of offshore financial institutions to invest in the onshore interbank bond market both prescient and a tacit acknowledgement of the scale of its debt problem. New rules aim to simplify the registration process, allowing foreign commercial banks, insurers, brokers and pension funds to buy bonds without being registered under the current qualified or renminbi-qualified foreign institutional investor quota systems.

This is a vital step for China, and for two reasons. First, it will soak up some of the fresh debt set to flood the market this year, a large slice of which will be issued by the sovereign, to meet rising global institutional demand, following the renminbi’s inclusion in the SDR. Julia Wang, greater China economist at HSBC, tips net central government bond issuance to rise by 15% this year, to Rmb2trn.

Second, it is a reform that is both much needed and long overdue. China has vacillated for years over when and how to open its bond markets to outsiders, fearing the scrutiny accompanying an influx of hot money seeking to identify undervalued – or overhyped – corporates and assets.

That the PBoC has finally decided to take the plunge underlines how urgent the issue of debt has become to legislators in Beijing.

“There is a pressing need for China to open up more to international investors,” said Jinny Yan, chief China economist at ICBC Standard Bank. “China’s bond market is less than 2% owned by foreign investors. Compared to other emerging markets, that share is very low.”

Few expect the onshore bond market to change much overnight. Tommy Xie, an economist at OCBC Bank, said he anticipated the ruling would “help China integrate its bond market into the global market” and deepen the onshore debt markets.

Timetable question

Yet the central bank neglected to add a timetable to its announcement, leaving experts to presume that foreign capital would filter only slowly into onshore bonds, over a multi-year period.

“I don’t see there being a major ramping up of foreign investor participation in the onshore debt markets for a long while,” said ICBC Standard’s Yan. “This is just that start. We will likely see a one-percentage-point increase per year, for at least the next 10 years. Still, that means sizeable absolute growth.”

This returns us to the original point about the relative pace of reform. When China says it wants to open its capital account, liberalise the exchange rate, or internationalise the renminbi (all of which it plans to do), it has one timetable in its head, stretching over years and even decades. Again, global investors hear ‘reform’, and expect to see change wrought overnight. When that does not happen, they question Beijing’s willingness to make the tough decisions.

This is to misjudge the way the ruling Party in Beijing thinks. It is a passive institution that reacts according to need, an example being the colossal stimulus programme unveiled in 2009 to bolster growth at the height of the global financial crisis.

When there is no critical need for change, its thought patterns follow an often simple process of cause and effect – A comes before B, then C.

So, when it comes to key financial reforms, “sequencing is important”, said Bill Stacey, chairman of Hong Kong-based think tank, the Lion Rock Institute. “China has been right to deregulate domestic interest rates before opening the capital account. Moving slowly to a more flexible currency and open capital account is difficult. The challenge for China is creating institutions and openness that can support those reforms.”

OCBC’s Xie also points to this sequencing process, noting that “capital account liberalisation is essential for the next stage of renminbi internationalisation”.

Guillaume Tresca, senior emerging market strategist at Credit Agricole, adds to the theme of interconnectivity.

“For China to succeed in rebalancing its economy to more private consumption, it needs to reform its financial system. But reforms will be very gradual, with the capital account opening over a very long period. They cannot do it rapidly or they risk mass capital outflows, which is a problem that has started to emerge over the past year.”

According to estimates from Capital Economics, US$640bn in net capital left the country in 2015, a record high.

For sure, there is no doubt that China is progressing more slowly with financial reforms than it could. Despite its inclusion in the IMF’s reserve-currency basket, Beijing is no closer to having a freely internationally renminbi than it did 12 months ago. Last summer’s stock market volatility, which followed a rapid run-up in share valuations, led to calls for sweeping change in how initial public offerings were chosen, priced and allotted. For months, Beijing flirted with the notion of switching to a Western-style IPO registration system, before scrapping the idea, a decision that now looks like a chance missed.

Barring an unforeseen financial crisis, it would be foolish to predict radical new financial reform over the next 12 months. But analysts do expect to see a few notable changes and alterations in how China’s financial economy is run.

HSBC’s Wang expects the central bank to move toward a policy rate corridor system, adopting the seven-day repo and reverse repo rates as its benchmark policy rates. “Such a policy framework,” she said, “would further reduce uncertainty over the interest rate environment in China and ensure continued money market stability.”

In the equity markets, the Shenzhen-Hong Kong Stock Connect scheme should gather scale and pace. In late May, Chinese securities regulators were expected to announce plans to stop listed firms arbitrarily calling a halt to trading in their shares – often a ruse to jack up their stock price. That decision could pave the way to China’s A-shares being included in the MSCI Indexes. Then there is sustainably responsible investing, an asset class that should get boost in the months ahead, when the National Association of Financial Market Institutional Investors sets out rules governing the sale of Green bonds by local corporates.

None of these reforms, in and of themselves, will change China, let alone the world. But add them all together and, over a period of years and decades, the image of a country undergoing radical and protracted reform starts to come into focus. In time, Beijing will wind up with an open capital account, a globalised currency and a freely floating currency – among many other things. Just don’t expect it to happen overnight.