Opening China's Capital Market

By Ye Haisheng

Moving towards a truly open market with a multi-dimensional framework.

C hina's capital market got its start in the early 1990s, and in less than 30 years it has grown into the world's third-largest stock and bond market. In its more recent past it has evolved into a truly open market with a multi-dimensional framework. And as it develops in the future it will need to combine international experience and practice with Chinese characteristics to progress in a balanced manner.

In the early 1990s, when the stock market was still in its infancy, B-shares were launched to bring in foreign investors.The B-share market was specially designed for foreign investors with investments made in US dollars and Hong Kong dollars. But in 2001 the market was opened to domestic investors, and in subsequent years there were important gains in trading rules, market management and accounting standards.

An initial key step was the introduction of the qualified institutional investor system which has gradually become a key investment channel. In 2002, the State Administration of Foreign Exchange (SAFE), the China Securities Regulatory Commission and other authorities launched the Qualified Foreign Institutional Investor (QFII) system, which allowed qualified foreign institutional investors to invest in the domestic A-share market within an approved investment quota.In 2011, in line with the internationalization of the renminbi,the Renminbi Qualified Foreign Institutional Investor (RQFII)program was introduced to allow qualified foreign institutional investors to use renminbi to make cross-border investments in domestic securities.

In 2016 and 2018, SAFE focused on simplifying foreign exchange management and facilitating currency convertibility. It has carried out two rounds of reforms of the QFII and RQFII programs,establishing the principle of open and transparent quota allocation.This has contributed to the smoother operation of the QFII and RQFII systems alongside of the Shanghai-Shenzhen-Hong Kong Stock Connect programs, which allow crossborder securities investments.These policies have basically removed restrictions on crossborder capital flows for foreign investors. As of the end of August 2018, a total of 299 QFII institutions had been approved with a total investment quota of US$100.5 billion. Nineteen countries and regions have become RQFII pilot areas with a total investment quota of 1.94 trillion yuan, and 199 RQFII institutions have been approved for a total quota of 628.7 billion yuan.

One of the key objectives of these reforms was to promote connectivity in the financial framework. In November of 2014, the Shanghai-Hong Kong Stock Connect was officially launched, linking the stock exchanges of Shanghai and Hong Kong. The program allowed investors from the China mainland and Hong Kong to trade in listed stocks on the other side of the border. There were limits on the scope of trading,but this ambitious program opened up a new channel for cross-border securities investment. It quickly won enthusiastic support from investors. In 2016, the Shenzhen-Hong Kong Stock Connect was launched to link the Hong Kong and Shenzhen markets.

The interconnection of the financial infrastructure promotes the direct connection between investors and products in the two markets, providing efficient crossborder investment services and eliminating cross-border capital exchange compliance requirements for individual investors. As of the end of August 2018, the Shanghai-Shenzhen-Hong Kong Stock Connect program had recorded net purchases of 571.6 billion yuan on the mainland market and net purchases of HK$795.3 billion in the Hong Kong market. The investment scale is now on a par with the qualified institutional investor programs.

Additionally, the mutual recognition of investment products has been an important advance in integrating the Hong Kong and mainland markets. The mutual fund recognition mechanism, which was put in place in 2015,complements the Shanghai-Hong Kong Stock Connect program and marks another policy breakthrough. In terms of foreign exchange management, there is no quota for any single institution or investment product. Registration and payments can be processed directly at a bank, and the mutual recognition of products enable residents on either side of the border to participate in cross-border securities investment and asset allocation.

More recently, the proposed introduction of depositary receipts has been a market focus.A link between the London and Shanghai stock markets is expected to be forged by the year-end. Eligible listed companies on the London Stock Exchange will be able to issue depositary receipts in China.Domestic investors will enjoy the same rights as holders of the underlying stock. Overseas registered companies will be permitted to list in China and this will be an important opening of the primary market - alongside the previously opened secondary market. It is beneficial to the gradual integration of the share issuance mechanism as well as accounting and regulatory standards.

Another milestone already reached by allowing foreign investors to open accounts directly in the A-share market. In 2013, residents from the Chinese territories of Hong Kong, Macao and Taiwan who worked and lived in the mainland were permitted to open A-share accounts directly. In 2018,with the approval of the State Council, foreigners working in China were allowed to open A-share accounts directly. This is a separate investment channel for foreign individuals. Unlike other channels, there are no quotas or custody requirements. It is a relatively simple and convenient path for the purchase of A shares by individual investors from overseas working in China.

Bond Market Opening

The opening of the bond market was achieved long after the stock market opened its doors to foreigners. In some ways the bond market opening mirrors the stock market opening, although there are some crucial differences.

The bond market opening makes use of direct investments and creates links to foreign trading platforms.

In 2010, the People's Bank of China allowed foreign central banks and monetary authorities as well as renminbi clearing banks in Hong Kong and Macao, and renminbi settlement banks for cross-border trade to participate in the interbank bond market within the limits of a pre-set quota. In 2015, foreign central banks, international financial institutions and sovereign wealth funds were allowed to use renminbi to invest in the interbank bond market and the foreign exchange market. This was not subject to any quota limitations though transactions were recorded.

In 2016, the People's Bank of China issued its Regulations on Further Improving Investment in the Interbank Bond Market by Foreign Institutional Investors(PBOC document No. 3, 2016), thereby enshrining further liberalizations. These include no administrative licenses for overseas institutions or interbank bond market nor the imposition of quotas for individual institutions or the market overall by SAFE. There is also no need for approval for the remittance of capital of overseas institutions. The interbank bond market does not have a lock-up period for investments and there are no quota restrictions or remittance limits, which greatly facilitates investments by foreign institutions. In July 2017, on the 20th anniversary of the return of Hong Kong to Chinese rule, a bond market interconnection was put in place, mirroring the existing stock market link. Foreign investors were able to invest in the interbank bond market through the interconnected market infrastructure. SAFE does not issue administrative licenses for bond issues, nor does it require foreign exchange registration. With no limit on investment, funds from bond investments can be remitted freely. As of the end of July 2018, the total net purchases of bonds reached nearly 300 billion yuan.

Despite the late start in the opening up the market, foreign investment in bonds has already caught up with stocks. As of the end of August 2018, foreign investors held nearly 1.7 trillion yuan in interbank bonds, accounting for nearly 3% of the interbank market bonds held in trust. In the first half of 2018, the net inflow of funds into the bond market reached 75.7 billion yuan and the contribution to the net inflow of securities investment reached 69.4%.

For the stock market, the primary market was opened after the secondary market. But for the bond market, both the primary and secondary markets were opened at the same time. International development agencies have been allowed to issue bonds in China since 2005, for example,although the boom in the panda bond market came after 2015. The cumulative issuance of panda bonds has exceeded 300 billion yuan,including offers by international institutions, governments,red chip and multinational corporations among others.There have been medium-term notes and ultra-short-term debt as well as longer term bonds.

Commodity Futures Market

In 2015, the State Council approved plans for crude oil futures trading in the domestic market with the participation of foreign investors. Due to market changes, the program was not officially launched until three years later. But ultimately foreign exchange management measures were put in place to facilitate trading. There was no investment limit for foreign investors and the remittance of funds has been free and convenient. Subsequently,foreign investors were allowed to participate in domestic iron ore futures and petrochemicals trading.

The absence of quota limits and foreign exchange restrictions have been the key elements in bringing in international investors and promoting international standards. By opening up futures trading to overseas investors, the degree of internationalization of China's commodity futures market has increased significantly.Domestic prices have become more closely correlated to international levels and related industries have benefited.Foreign investors have actively participated in China's crude oil and iron ore futures market, and accumulated net remittances have exceeded US$100 million.

The Significance of the Market Opening

The opening up of the domestic capital market has accelerated China's integration into the world economy. In the early days of the reform and opening up program, overseas capital investment in China was mainly through foreign direct investment channels,as well as foreign exchange borrowings related to direct investment. The main players involved were large-scale manufacturers (multinational companies), consumer retailers and commercial banks as well as international organizations and foreign governments. Individuals,investment institutions and asset management institutions had few channels to enter the Chinese market. The opening up of the capital market has facilitated investments by overseas individuals, asset management companies,foreign central banks, sovereign wealth funds and pension funds, allowing them to participate in China's rapid economic growth. Along with the continuous opening up of the capital market, A-shares have been included in the MSCI and FTSE Russell international indices. Citigroup,Bloomberg and JP Morgan are considering incorporating renminbi bonds in their international indices. China's stock market and bond markets have officially become an important part of the international capital market, and China's economic integration into the world economy has been enhanced.

Stabilizing the Balance of Payments

The opening up of the capital market has brought about significant changes in China's balance of payments and international investment position. After the Asian financial crisis, with the huge boost in trade brought about by China's entry into the World Trade Organization, the nation's international balance of payments showed a large surplus in its trade in goods and in direct investment. Securities investments were negligible.

Against the background of strong expectations of renminbi appreciation and limited exchange rate flexibility,China's central bank ended up holding large amounts of foreign exchange reserve assets. That meant that on the asset side it had low yield reserves with a higher yield on the debt side from inbound direct investment. The opening up of the capital market has rapidly changed the structure of this international investment position. The proportion of securities investment liabilities to total liabilities has now reached one-fifth, and this will continue to grow in the future.

Since 2015, the trade surplus has continued to fall,direct investment has swung between a small surplus and a small deficit, and the net inflow of securities investments have become an important source of surplus on the capital and financial account. Since the bond market was opened to foreign investors in 2016, there has been a net inflow of funds. In 2017 that net inflow was three times the net inflow of 2016. Since the beginning of this year, the MSCI, FTSE Russell, Bloomberg Barclays and other index companies have announced the inclusion or an increase in the weighting of the Chinese market in their indices. It is expected that in the next few years, the trend of greater deployment of assets in China's stock and bond markets will become even more obvious. The opening up of the capital market will continue to be an important stabilizing factor in the nation's balance of payments position.

Paying Attention to Related Risks

The opening of the capital market will bring about a rapid rise in cross-border capital flows. As investors chase higher returns and respond to cyclical factors, disorderly flows of funds may result in shocks to the market. This could even lead to systemic financial risks. Emerging market economies have had many such painful lessons in the past.

At the Boao Forum for Asia in April this year, PBOC Governor Yi Gang proposed a general guideline for the continued opening of the financial sector.He said three principles needed to be followed, and the first of these is to provide preentry national treatment and negative list management for investments. The opening up of the financial industry should also dovetail with reforms of the exchange rate mechanism and capital account convertibility.Additionally, there must be sufficient attention paid to the prevention of financial risks and ensuring that financial supervision keeps pace with the degree of openness.

Three principles need to be followed, and the first of these is to provide pre-entry national treatment and negative list management for investments

The author is deputy director of SAFE's Capital Account Management Department