Regulation: China's limited liberalization
China’s financial regulators have undergone dramatic changes since president Xi Jinping took power five years ago.
The banking and insurance regulators have merged; the door has been opened to foreign bond and equity investors; and international asset managers, banks, brokers and insurers have been told they can hold majority stakes in local firms.
There is little doubt that more foreign involvement in China’s financial markets is needed. Foreign banks held a mere 1.3% of the banking assets in China at the end of 2017, according to KPMG.
By the end of the first quarter of this year, foreign institutional investors held just 1.7% of outstanding bonds and 2.1% of outstanding equities, according to CEIC data.
China has taken steps to address the lack of foreign involvement in its financial system. In November, it announced that a wide variety of financial institutions and asset managers would be given a chance to hold majority stakes in local institutions. This includes removing a 20% ownership cap for foreign banks.
In the capital markets, China has gone on a similar liberalizing spree. It launched its Stock Connect programme three years ago, allowing foreign investors to go through Hong Kong to make bets on the Shanghai and Shenzhen markets. Last July, it followed up with the similar Bond Connect scheme, which made it much easier for foreign investors to buy renminbi bonds. It is now in discussions about further smaller initiatives, including a market access link with London.
China appears to have shifted position from flirting with to embracing foreign investor access. But it would be a mistake to expect these changes to have much impact, at least in the short term. It may be willing to open its doors, but China cannot force anyone to step inside.
So far, foreign banks have been wary of exercising their new-found freedom; there has been no stampede for access. In truth, the 20% cap was never a problem for most of them.
Foreign investment bankers, who have muddled through with minority ownership in joint ventures over the last decade, know how hard it is to generate large fee revenues in China. Chinese banks and securities houses are much more willing to put their balance sheet on the line, ensuring that winning new business is not just expensive but risky.
[There] is a fear among foreign investors about the strength of China’s bond issuer base
There is also the tricky question of how foreign banks should enter the market. Do they buy their way in or expand organically? China’s biggest banks are certainly too big to target, even if the government were to approve such an acquisition. That means the only realistic targets are relative minnows, either city commercial banks or rural lenders. But they tend to have too narrow a focus geographically, and are unlikely to have the experience or risk controls to offer any real synergies.
Fitch, a rating agency, notes that these smaller banks also face more pressure on their bottom line than their larger rivals.
There is a related issue in the opening up of China’s bond market to foreign investors.
Bond Connect has been a success when you consider the headline numbers: by the end of the first quarter this year, 288 foreign institutional investors had accessed China’s market, driving volumes of Rmb162.6 billion ($25.4 billion).
But bankers and investors admit most of this money is going into very short-term debt, largely issued by China’s biggest, safest banks. Those are not the sorts of deals that would benefit from the eagle eye of foreign bond investors.
Technical factors are one reason why foreign bond investors are reluctant to spread their wings further, especially the lack of a delivery-versus-payment scheme to ensure that foreign investors are not forced to wait for their securities after paying cash. This is something the regulator is said to be working on.
But the bigger hurdle is a fear among foreign investors about the strength of China’s bond issuer base. So far this year, 11 issuers have defaulted; more are likely to follow.
Foreign investors admit that a lack of transparency, a questionable credit rating industry and uncertainty over which companies will be bailed out by the government are all deterrents to wider access.
None of this means that China’s liberal turn should be downplayed. But it has only taken the first steps on a long road towards bringing foreign capital and expertise to bear on its banking and capital markets.