Towards free markets

China’s capital account liberalisation has been a topical subject in the financial markets over the past few years. While institutions globally are taking a keen interest in any announcement related to liberalisation moves, it is clear that the Chinese authorities are adopting a more measured and deliberate approach to any liberalising policy shifts whilst seeking to attain full convertibility of the RMB.

This deliberate approach has been translated into several policies including: the Shanghai-Hong Kong Stock Connect, that permits investors greater mutual access to investing directly in each others’ markets; the Shanghai Free Trade Zone (FTZ), which currently allows for free cross border movement of RMB; and other initiatives such as the Qualified Foreign Institutional Investor (QFII) and the Renminbi Qualified Foreign Institutional Investor (RQFII) schemes. All are designed to gradually open up Chinese markets to foreign investors. Tony Wang deputy general manager of global markets at Bank of China (Hong Kong), speaking at the RemninbiWorld 2015 conference accurately summed up the Chinese government’s policy towards liberalising the capital account by stating “The ultimate solution is for China to open the capital accounts one by one, then the RMB positions on both sides will equalise. But you have to be really cautious. You have to do it step by step.”

Shanghai-Hong Kong Stock Connect
The Hong Kong-Shanghai Connect, established in October 2014, was the first initiative of its kind aimed at allowing investors mutual access to both stock markets. As a pilot scheme, authorities on both sides exercised conservative policies placing limits on investors, eligible products as well as overall daily quotas. For the first phase, only mainland investors possessing RMB500,000 ($77,000) in their investment accounts were eligible. For the Hong Kong investor, there was no such quota although they could only trade certain stocks listed on the Shanghai Stock Exchange in the initial stages and still can only trade A-shares listed in Shanghai today. Despite the limited scope of the link, the significance and potential for the Shanghai-Hong Kong Stock Connect is enormous. Paul Chow, the former chief executive of Hong Kong Exchanges and Clearing, attended the RenminbiWorld 2014 conference held in the same month it was launched. In his conference speech he said “The trading link marks one of China’s biggest steps toward opening up its capital account, increasing use of the RMB and turning Shanghai into an international financial centre. It will give foreign investors greater access to Chinese companies, which will help reduce the dependence of the world’s second-largest economy on exports and infrastructure spending”.

What has been achieved so far?
Like most other policies focused on opening up Chinese markets, the Shanghai-Hong Kong Stock Connect is a pilot scheme that has its limitations and authorities will likely take a cautious approach in removing various restrictions. The success of the scheme will justify the launch of other schemes but this will not happen overnight. Gin Ye, legal counsel at Clifford Chance speaking on the Shanghai-Hong Kong Stock Connect panel at RemninbiWorld 2015 updated the audience on the progress of the link stating “we will not be in a position to offer solutions for all concerns at the time of launch. After launch, we will continue to allocate resources to explore solutions.”

Overall, with the exception of the opening week, the data from the Connect shows relative stability on both northbound and southbound activity. It is encouraging to note that the difference between the volumes on each exchange in terms of buying volumes is less than RMB30 billion ($4.6 billion) which means that net cross border flows have been fairly balanced.

Data provided by the exchanges shows that the total trading value of northbound stocks has reached RMB1.538 trillion ($240 billion) while total trading volume of the southbound stocks has reached HK$742 billion ($96 billion). Even though the quota for the aggregate northbound net-buy of RMB300 billion ($46 billion) and the aggregate southbound net-buy quota of RMB250 billion ($39 billion) were not breached in the first year, the daily quota for northbound was exhausted on the opening day while Hong Kong Exchange share turnover shows that southbound trading only reached its cap in April 2015. Overall the results have been encouraging with both volumes stable and a fairly even exchange of cross border flows.

The authorities would like to use this model for further links with other markets. It has been reported that Britain and China will carry out a feasibility study for a stock exchange connect scheme between London and Shanghai, according to a UK Finance Ministry document posted on the British Embassy website in Beijing. The model of connecting securities markets has so far worked well, and is yet another scheme towards China’s market liberalisation.

The Shanghai Free Trade Zone
While the Shanghai-Hong Kong Stock Connect experimented by allowing China’s securities market to open up to participants of another market, the Shanghai Free Trade Zone (SFTZ), established in December 2013, was a different experiment that permitted China to assess how a limited area within its borders would perform with free capital movements, foreign currency deposits and interest rate liberalisation. A successful outcome would encourage the implementation of this model across the whole country and eventually lead to a liberalised capital account.

The initial success of the SFTZ was limited and there were criticisms from both local and international market participants on the slow implementation of the project. Li Lin, head of the strategy and development department at Shanghai Pudong Development Bank who attended the RenminbiWorld 2014 conference in Shanghai acknowledged a wide spread sentiment about the SFTZ by asserting “China’s new FTZ is intended to promote higher levels of foreign trade and investment through preferential tax policies, deregulation and more sectors open to foreign companies. However, in reality, these FTZ reforms remain largely rhetorical, and foreign companies are waiting for Shanghai to live up to its promise.”

Further liberalisation for the SFTZ
The Chinese authorities have been well aware of the initial delay in delivering the highly anticipated reforms of the SFTZ. Their most significant action to date came in October 2015 when the regional government in Shanghai released its policy paper on pursuing further SFTZ liberalisation. The paper contains an ambitious road map to liberalisation and if implemented could have a significant impact on the liberalisation of the capital account. The main plans cited in the policy paper included the following: firstly, to increase the current $50,000 annual individual quota for RMB foreign exchange conversion to a much higher threshold; secondly, to expand the quota as well as available channels to invest overseas, for domestic individuals under a Qualified Domestic Institutional Investors (QDII) program; thirdly, to allow non-financial enterprises to convert RMB to foreign currency and trade foreign exchange in the SFTZ within quotas; and fourthly, to allow greater market access to foreign investors by permitting them to set up joint ventures with local companies in the FTZ and to remove requirements for the Chinese partner company to be a securities company. The plan is certainly ambitious and long awaited by market participants. If implemented properly, it will allow the SFTZ to serve as a model for other economic zones in China.

Thomas McMahon, CEO of UD Trading speaking at RemninbiWorld 2015 cautioned against being overly optimistic about the success of the SFTZ and its impact for other zones. “From an outside perspective, everybody would like China to open up and the Shanghai Free Trade Zone to be successful. But the reality is that entities like Guangdong, Guangzhou and Fujian, have very different economic drivers from Shanghai. It is almost as if you’re talking about four free trade zones, but in reality you are talking about four very different economies.”

Market based initiatives
Wang was very optimistic in his assessment of how the path towards China’s capital account liberalisation was unfolding overall. Speaking on the same panel as McMahon at RenminbiWorld 2015, he boldly stated “I think we are entering a golden age for China. From this year you will see more capital accounts opening and this is more important than the previous reforms.”

Wang has reason to feel optimistic. He stated that to really appreciate PBOC’s efforts in liberalising China’s markets, one should not just focus on the one time currency intervention by the PBOC in September 2015 that caused its currency to strengthen to 6.4 against USD. To get a clearer picture of PBOC’s initiatives Wang stressed that offshore market participants need to appreciate how such policies had started as early as 2004 when offshore RMB was allowed to be freely traded by foreign institutions, and how for the following 10 years the policies of the PBOC had evolved towards being more flexible with regard to liberalisation.

Wang went on to say that 2015 has been the most significant year to date for liberalising the capital account. “This year the PBOC further opened the markets by allowing the foreign investors to invest in the onshore inter bank markets. PBOC also eliminated the upward limits for foreign currency deposits. In the past you have QFII and RQFII limits but now you can see China removing these limits. We have been waiting for this policy for a very long time.”

An alternative view
While Wang focused on China’s gradual path to liberalisation, he also commented on the currency intervention explaining that “China being a huge economy cannot simply rely on market forces and limited intervention (for its RMB) was necessary. The PBOC therefore has done a great job because even as they intervened, they communicated their policy clearly to the markets.”

A fellow panelist, however, did not share this view. Christopher Balding, associate professor at Peking University HSBC Business School said “The PBOC intervened to bring offshore and onshore rates closer. The real question is whether China is going to allow the RMB to be freely traded at a market price. Right now, there’s some real questions about that and investors in Hong Kong are definitely concerned.”
Balding went on to put some perspective on the size of the offshore RMB market and cautions on being overly optimistic about the growth prospects of the offshore centers. “If you add up all the offshore RMB deposits, in places like London, Luxembourg, Taipei, Singapore, etc. You are still only at about RMB2 trillion which in the grand scheme of things is the size of a mid to small sized Chinese bank. It’s definitely not what you would consider a large market.”

On the importance for Chinese banks of using offshore RMB as collateral in the OTC markets, Balding commented that “I would disagree with this because I can see banks saying that we don’t want to use RMB as collateral as it is simply not as widely traded.”An interesting point brought up by Balding relates to the flow of offshore RMB back into China. Over the past two years, the Chinese authorities have gradually opened up more cross border channels for the RMB to flow back into China. In July 2013, the authorities increased the quota allowing investors to use RMB obtained offshore to $42 billion for investment into China’s domestic capital markets. Balding mentioned that this flow back mechanism is actually shrinking the offshore RMB market. “One of the things that has been happening in recent months is that short and middle term offshore RMB loans aren’t being rolled over and those firms are instead going for onshore RMB financing. So the RMB essentially is being repatriated back to China. So in the Hong Kong market in recent months, you’ve actually seen a shrinkage in the amount of RMB available for offshore deals”

Where to from here?
China’s capital market liberalisation has to be viewed from a macro context and take into account a historical perspective as Wang rightly pointed out. Whether it is the experimental approach of using the Shanghai-Hong Kong Stock Connect and the Shanghai Free Trade Zone, or the gradual move of removing barriers to entry for foreign firms or even the widening of quotas for the qualified investor programs, it is quite evident that China’s road to liberalising its capital account is well underway.

Concerns exist about the lack of liquidity for some RMB products as well as the overall amount of the offshore RMB currency available relative to the well-established G3 currencies. However, it is important to bear in mind that it was only 10 years ago that the RMB was allowed to be traded outside China for the first time. Given the short period of time, a variety of liberalisation moves have taken place. There has also been investment in the creation of hubs, clearing and settlement platforms as well as corresponding banks, all of which serve in putting the right infrastructure in place for the future. The path is being slowly paved for a move towards full liberalisation. The question of “when” will depend on the Chinese authorities.