China's Stock Connect Programs And the Expanding Role of the Renminbi

By staff reporter Jing Likun

What changes might emerge from China's connect programs and how might commercial banks respond?

C hina has been gradually opening up its capital market. Projects such as the Shanghai-Hong Kong Stock Connect program, which links share trading on the two stock markets, as well as the Shenzhen-Hong Kong Stock Connect,and Bond Connect (a bond trading vehicle linking the Chinese mainland and Hong Kong) have been rolled out already and the Shanghai-London Stock Connect program will allow cross-trading between these two major markets. In order to find out what changes might emerge from these programs and how commercial banks might respond, China Forex interviewed Xu Ying,general manager of international business at the Industrial and Commercial Bank of China (ICBC) Shanghai Branch,Lin Lin, general manager of international finance at the Agricultural Bank of China (ABC) Shanghai Branch, and Fang Min, general manager of international business at China Construction Bank (CCB) Shanghai Branch.Following are excerpts from the interview.

China Forex: The Shanghai-Hong Kong Stock Connect Program was launched in 2014, followed by the Shenzhen-Hong Kong Stock Connect program.More recently there have been preparations for the Shanghai-London Stock Connect program. What significance do you see for the banking sector from these initiatives?

Xu Ying: The Shanghai-Hong Kong Stock Connect program was China's first channel for securities market trading linking stock exchanges on the mainland and Hong Kong. Eligible investors in mainland China were permitted to invest in Hong Kong-listed securities while Hong Kong and international investors were allowed to invest in Shanghai-listed A shares. The launch of the program meant that China had truly opened its stock market to the rest of the world. This built on the Qualified Foreign Institutional Investors (QFII)and the Qualified Domestic Institutional Investors(QDII) programs which had permitted stock investments by means of a limited number of institutions.

Lin Lin: The significance of the Shanghai-Hong Kong Stock Connect program lies in three areas. Firstly, it has been an important part of China's effort to open its financial markets, and this has already resulted in significant benefits. Before the launch of the program, for example,the mainland stock markets were struggling. The Shanghai cross-border link, later followed by a similar platform for Shenzhen, has channeled Hong Kong support for blue chips on mainland stock exchanges.

Secondly, the programs were a response to demand. When the first program was launched, the renminbi cross-border settlement pilot project had already been in operation for five years, and the scale of offshore use of the domestic currency had expanded considerably over this period.However, there was a shortage of channels for renminbi asset allocation. The program was a response to this kind of requirement.

Thirdly, we can see the future potential in having this window on the domestic market for the global investment community.It will allow China's listed companies to become better known outside of China.

Fang Min: The Shanghai-Hong Kong Stock Connect program has been warmly welcomed by investors since its launch in 2014, and it has come to symbolize China's opening up of the capital market. By allowing domestic institutions and eligible individuals to engage in direct cross-border securities trading, we are expanding investment channels and promoting the healthy development of the capital markets on the mainland and in Hong Kong.

China Forex: What are the characteristics of the capital flows under the Shanghai-Hong Kong and Shenzhen-Hong Kong Stock Connect programs?What are the factors that determine these capital flows?

Lin Lin: Since the launch of the Shanghai-Hong Kong and Shenzhen-Hong Kong stock programs, the total amount of capital flowing across the border and between these exchanges has grown year by year.But capital flows have varied considerably. When the Shanghai-Hong Kong Stock Connect program was launched, for example, net capital inflows were largely in balance. However, beginning in 2015 the flows were clearly in favor of the Hong Kong exchange. Southbound capital was 6.87 times that of the capital flowing north in 2015 and 5.25 times that total in 2016. However, by 2018 there was a sharp decrease in capital flowing south while the total of funds flowing into Shanghai rose 2.05 times. Under the Shenzhen-Hong Kong Stock Connect program, capital inflows between Shenzhen and Hong Kong have been in relative balance since the program began in December 2016.

Xu Ying: Since the launch of the Shanghai-Hong Kong Stock Connect program, cross-border capital flows have followed overall market trends. In 2016 and 2017 as the Hang Seng Index made significant advances, purchases of Hong Kong shares that were cleared by ICBC outpaced investments in Shanghai from Hong Kong.Capital outflows from the mainland outpaced inflows by a 10 to 1 margin. But the ratio fell to 1.5 to 1 in the first half of 2018, as the Hang Seng Index lost ground.

China Forex: What roles have commercial banks played in the opening up of the capital market?

Xu Ying: Commercial banks have played three main roles. First, commercial banks have served as the main vehicle for settlements. They have provided quick and efficient clearing services under programs such as the Shanghai-Hong Kong Connect, Bond Connect as well as the trading of crude oil futures in Shanghai and the creation of the international board of the Shanghai Gold Exchange. Second,commercial banks work as an investor and market developer. For example,the ICBC trades on the international board of the Shanghai Gold Exchange, and it has helped develop the QDII program. Third, commercial banks supply other critical tools such as account opening and investment facilitation,as well as exchange rate and interest rate-related services.

China Forex: What are some of the opportunities and challenges that commercial banks have encountered under these programs?

Lin Lin: Opportunities can be found in a number of areas.The opening up of the capital market has brought crossborder financial business,and the programs linking the Shanghai and Shenzhen stock markets with the Hong Kong market are among the most prominent initiatives. But there is also the arrangement which allows overseas institutional investors to invest in the domestic interbank bond market, as well as the Bond Connect program and the mutual recognition of funds initiative between the mainland and Hong Kong.These have not only helped improve the structure of cross-border business for the nation's commercial banks,but they have also increased the volume of international settlements under the capital account. Cross-border settlements of renminbi have recorded large increases in volume and there has been an expansion from pure trade receipts and payments to comprehensive investments and financing activities. In addition, the opening up of the capital market will bring in new customers for crossborder financial services.Chinese banks will be able to make use of their home court advantage in serving nonresident customers.

On the other hand,there are challenges and commercial banks need to strengthen their capacity to meet these challenges. They need to be up to the task of providing comprehensive cross-border financial services.In addition to cross-border settlement services with international settlement networks, commercial banks should provide products for investors at home and abroad to hedge against exchange rate risks. They also need to upgrade interdepartmental collaboration. Commercial banks need to be able to combine different operating roles, including planning,promoting and managing local and foreign currency business. They also need to boost their capacity for network development. Commercial banks must develop their networks in order to react quickly to changes in demand in the financial businesses.

China Forex: How have the stock connect programs contributed to the internationalization of the renminbi?

Xu Ying: According to the 2018 Renminbi Internationalization Report recently released by the People's Bank of China,cross-border renminbi receipts and payments had reached 9.19 trillion yuan as of the end of 2017. One of major features is that investments in the domestic bond market helped spur a rapid rise in renminbi cross-border settlements. In 2017, cross-border receipts and payments under the current account, which primarily covers goods and services, amounted to 4.37 trillion yuan. Cross-border receipts and payments under the capital account amounted to 4.83 trillion yuan, and 1.91 trillion yuan of that total was from investments in securities via the QFII program and RQFII (Renminbi Qualified Foreign Institutional Investors) plan as well as the Shanghai and Shenzhen-Hong Kong Stock Connect initiatives. This was an increase of 219% yearon-year and was the primary contributor to the growth in capital account volume. The above data indicate that the opening up of China's capital market has had a profound effect on renminbi internationalization.The currency's expanded use outside the country's borders is now driven by both trade and investment -and not just trade alone. This shift will more effectively promote the development of cross-border renminbi business. In the next phase of development, the launch of the Shanghai-London Stock Connect program and the implementation of regulations that allow overseas individuals to invest in the domestic securities market will expand renminbi investment channels. Meanwhile, more avenues for renminbi to return to China will support the internationalization of the Chinese currency.

Fang Min: There are three areas where we can see the effects on renminbi internationalization from the opening up of the capital market, especially through the Shanghai-Hong Kong Stock Connect program.

First of all, from the perspective of renminbi circulation,the Shanghai-Hong Kong Stock Connect program allows mainland investors to buy Hong Kong stocks using renminbi. This provides a channel for domestic renminbi to flow into the international market. At the same time, Hong Kong and overseas investors are also allowed to purchase domestic A-shares with offshore renminbi, which expands the return route for domestic currency that is parked offshore. This is in line with the strategic planning of China's renminbi internationalization initiative.

Additionally, the Shanghai-Hong Kong Stock Connect Program strengthens the role of Hong Kong as the premier offshore renminbi center. It increases crossborder renminbi transactions and contributes to Hong Kong's economic development. Presently, as China's capital account is not fully convertible, the offshore center in Hong Kong is at the forefront of renminbi internationalization. The expansion of this stock market links help with the circulation of onshore and offshore domestic currency.With its trusted status among international investors, Hong Kong is best equipped to fill this important role.

Lastly, the Shanghai-Hong Kong Stock Connect program supports renminbi internationalization by helping improve China's domestic A-share market. The program unlocks new market potential and can also help upgrade domestic market rules, such as the use of T+0 trading. Despite possible obstacles in the early stages, a more efficient A-share market will be beneficial to renminbi internationalization.

China Forex: Risk prevention measures have been built into the Shanghai-Hong Kong Stock Connect program.For example, mechanisms such as transaction limits and investor qualification requirements have been put in place. Nevertheless, there may still be some potential risks. Where do you see

The Shanghai-Hong Kong Stock Connect program is still in its infancythese risks?

Fang Min: As the Shanghai-Hong Kong Stock Connect program is still in its infancy,there are some potential risks.

The first is the risk from the institutional differences.Different trading rules between Shanghai and Hong Kong create risk. Those rules include information disclosure by listed companies and the impact on stock prices, as well as market holidays and trading hours, tax policies and so on. In view of this kind of risk, there is a need for more regulatory convergence.

At the moment, the regulatory systems are independent of each other, but increased cross-border securities investments require more supervisory cooperation.So there are challenges ahead. To face these challenges, we need to apply the principle of home court rules, which means there must be compliance with the laws and regulations of the place where the securities are listed, where the financial institutions are located and where transactions are settled. There is a need for some flexibility to reduce operating costs and improve market efficiency.

There are also risks associated with closer ties to the international capital markets. The Shanghai-Hong Kong Stock Connect program has strengthened the links between domestic and international trading and that means that the domestic market will be more directly affected by abnormal fluctuations on global markets.This increases the difficulty of managing monetary and fiscal policies. In accordance with the internationalization of the renminbi, China's securities market should be further improved in line with international conventions and the risk prevention system should be constantly improved.

Additionally, there are risks from exchange rate fluctuations. Transactions under the Shanghai-Hong Kong Stock Connect program are settled in renminbi. Individual and institutional investors may have a huge need for foreign exchange settlement and sales. When there are fluctuations in the international financial market or the domestic economy, the renminbi exchange rate will fluctuate accordingly. This may create losses for investors. In the next stage of the program it is reasonable for regulators to relax the supervision of financial derivatives of the Shanghai-Hong Kong Stock Connect program, and for banks to provide more tools such as foreign exchange forwards and options as foreign exchange hedging tools.

China Forex: On October 12, the China Securities Regulatory Commission issued trial rules for the depositary receipt business under the Shanghai-London Stock Connect program. On the same day,the Shanghai Stock Exchange and China Securities Depository and Clearing Co., Ltd. issued supporting business rules and sought public comments. These actions indicate that the Shanghai-London Stock Connect program will be launched soon. What expectations do you have for the program?

Lin Lin: The Shanghai-London Stock Connect Program will have the following effects.

In the first place, the program is another major innovation in the opening up of China's capital market,following in the footsteps of the programs linking the Hong Kong market with Shanghai and Shenzhen. It will promote two-way investment and financing. By listing shares on a developed market like London, domestic enterprises will attract attention from overseas investors.At the same time, these companies will need to play by international rules. For domestic investors, the program will help them participate in Western securities markets,allowing them to broaden their investment portfolios and reduce risk through diversification.

The program is also conducive to China's integration into the global financial market. London is one of the world's key financial centers, with sound financial institutions and a well-developed regulatory system.The Shanghai-London Stock Connect Program will provide an opportunity for China to learn from London's experience. This will make a major contribution to China's financial markets and promote Shanghai as an international financial center.

Finally, the program is conducive to increasing the volume of offshore renminbi transactions. The offshore market in London has grown into the world's largest offshore renminbi foreign exchange trading center, with average daily trading of 70 billion pounds sterling. At the same time, it is the second largest offshore renminbi clearing center, trailing only Hong Kong.The daily volume of clearing by the local renminbi clearing banks has averaged more than 40 billion yuan. Moreover, there is a big demand for hedging products. Investors under the Shanghai-London Stock Connect program will face risks from fluctuations in stock prices as well as exchange rates.Their need for exchange rate hedging products will help enrich trading and promote the healthy development of the offshore renminbi market.

Fang Min: The Shanghai-London Stock Connect program differs from the Shanghai-Hong Kong Stock Connect model as eligible listed companies in Shanghai and London trade depositary receipts on the securities market of their counterpart market. Under this type of trading, investors take part in the settlement of depositary receipt transactions in a similar way to stock transaction settlement.Additionally, the depositary receipts and the underlying stocks can be converted into each other. In other words, while the Shanghai-Hong Kong Stock Connect program follows the model in which "investors cross the border and products do not" - investors from Shanghai and Hong Kong directly trade stocks on each other's securities markets,the Shanghai-London Stock Connect program will follow the model under which "products cross the border and investors do not". This is to say that traders from Shanghai and London convert stocks on the counterpart market into depositary receipts and list them on the local market. The latter trading model has the following advantages. First,it conforms to international practice and protects the rights and interests of investors. Second, it clarifies investors' obligations and legal responsibilities.Third, it ensures the safety of depositary shares as an underlying property because the depositary opens a separate account for depositary receipts and thereby protects the asset.

The Shanghai-London Connect program is of critical importance in deepening Sino-UK financial cooperation and expanding the two-way opening of China's capital market. It will promote the development of cross-border securities investments, deepen China's domestic markets and boost their competitiveness. The program will provide a channel for raising capital across international borders.