Capital Account Convertibility and China’s Drive to Open its Financial Sector

By Ba Shusong and Feng Chao

Important areas include the primary share market as well as markets for derivatives and foreign exchange.

C hina will push ahead with its efforts to open up the financial sector in the near term and allow greater convertibility of the currency under the capital account.Important areas where convertibility needs to be expanded include the primary share market as well as markets for derivatives and foreign exchange.These reform efforts will be made under a framework of stepped up macroprudential regulation and strengthened risk oversight.

China has been making steady gains in opening its financial sector, particularly in the current period of international asset reallocation. Recently, there have been significant adjustments in global liquidity amid Sino-US trade friction and US financial market volatility.In order to hedge against these factors, some global asset managers have been turning to markets which have a low correlation with those in the US and Europe.These markets need to meet a threshold of minimum requirements; they must have free capital flows,similar trading practices to developed markets and a more reliably regulated trading environment. China’s renminbi asset market is suitable in most aspects with one large exception - restrictions on access for foreign investors.

As China upgrades its economy it has also seen a restructuring of its balance of payments. It is estimated that the trade surplus will gradually decrease while international capital inflows will play a greater role in maintaining equilibrium in the payments balance.Against this background, a new trend is emerging in opening up the capital account. In July, for example,the Chinese government announced the Relevant Measures for Further Opening Up the Financial Sector. In September the foreign exchange regulator announced it would abolish investment quota restrictions for the Qualified Foreign Institutional Investors (QFII)and the Renminbi Qualified Foreign Institutional Investors (RQFII) programs.This article examines these measures and sheds light on what policies might be implemented in the future.

Past Progress

Internationally, there is no real standard for capital account convertibility. The International Monetary Fund (IMF) offers an assessment framework in its annual Report on Exchange Arrangements and Exchange Restrictions, however, and we’ll use that to give us an idea of how China compares with other countries at this time.

While there have been marked improvements in opening the capital account,some key areas still show limited openness, and these include cross-border asset allocation. According to the IMF’s Report on Exchange Arrangements and Exchange Restrictions(2018), of the 40 items in the seven broad categories under China’s capital account, 38 of them or 95% are convertible, partly convertible or basically convertible. Only two items are not convertible at all.On the surface, China appears to be close to the target of full capital account convertibility. But among the above-mentioned 38 items, only 10 of those with at least some degree of convertibility are related to direct investment.Investments in bonds are partially convertible and there is no convertibility for derivatives transactions and cross-border financing between residents and nonresidents.

From the perspective of global asset deployments,overseas capital allocations for Chinese assets are at low levels due to narrow investment channels, structural inefficiencies and an inability to conduct risk hedging.For instance, the utilization rate of the QFII and RQFII quotas has been relatively low. As of the end of August 2019, a total of 292 investors had been granted approvals for investments of a combined US$111.4 billion in Chinese stocks. But this represented only 37%of the total QFII quota of US$300 billion. As for RQFII,the total quota was 1.99 trillion yuan, and the utilization rate only 35%. On the other hand, although Chinese residents have seen the country’s economy expand rapidly with a significant rise in disposable income,more than 90% of the country’s residents have no funds invested offshore. The rate of Chinese overseas asset allocation is 4%-5% of total allocations, much lower than the average rate of over 15% in developed countries.

Despite the opening of some segments of China’s capital market, access to the primary market is limited.That has constrained financing channels for enterprises and inhibited growth of the real economy. China’s secondary market has been open to overseas capital since the introduction of the QFII program in 2002.The Shanghai-Hong Kong Stock Connect program was launched in 2014, linking the stock markets in the two cities. That was followed by the Shenzhen-Hong Kong Stock Connect project in 2016 and the Bond Connect plan in 2017. More recently, the Shanghai-London Stock Connect program was put in place, allowing access to both primary and secondary market offers (though initially the primary market access is for Chinese companies listing shares in London).

While there is no convertibility for primary share offers by foreign companies on the domestic market,removing the existing barriers should not be that difficult as there is convertibility in place for the secondary market by means of the stock connect program. Foreign investors can also issue bonds to mainland China investors through the Hong Kong market by using the Bond Connect mechanism. With some degree of access to the primary and secondary markets, a loosening of controls over the primary share market is not unthinkable. Removing the remaining obstacles to greater access would not only expand the financing channels for enterprises in mainland China,but would also provide more good quality investment options to domestic investors.

In terms of the foreign debt market, China has largely made good preparations for a gradual opening by improving the framework for macro-prudential regulation. It also has seen a steady climb in the use of offshore borrowings. The country’s cumulative balance of foreign debt reached US$1,965.2 billion as of the end of 2018.

China also has stepped up its efforts to open the foreign exchange market, but foreign institutions account for less than 1% of the transactions on the interbank foreign exchange market. Foreign participants in the Chinese market need financial derivative tools to hedge against risk, and the shortage of products is curtailing their activities. Additionally,allowing more foreign participation would also enhance China’ global pricing power. So greater access to the derivatives market should be part of the opening up process in the financial sector.

Advances have also been made in opening up the commodities markets.Overseas investors have been allowed to trade in renminbi-denominated crude oil futures, which have been listed on the Shanghai International Energy Exchange. Foreign investors have also been permitted to trade in iron ore futures on the Dalian Commodity Exchange.

Bringing in Overseas Capital

China’s opening up of the financial sector is largely aimed at bringing in overseas capital, assisting foreign investment by domestic enterprises and enhancing the interconnection between overseas and domestic markets.

The general consensus in the past had been that opening up the financial markets could result in unwanted volatility. But those concerns were overdone.In fact, opening up the financial sector is now needed more than ever to meet the financial requirements of the real economy. As participants in the world’s second largest economy, Chinese companies need to be competitive in the global marketplace. This is particularly true against the background of Sino-US trade friction. Overseas capital brought into China will not only participate in this country’s economic growth, but also help ensure sustainable, high-quality development. Nonetheless,adapting to the rules and conventions of the Chinese market is costly, and not all foreign companies will be able to bear that cost.Ultimately, this is likely to mean only the larger foreign financial institutions are able to compete successfully in this market.

Foreign Investment by Domestic Enterprises

China encourages enterprises to go global and deploy some assets abroad according to regulations.The nation’s overseas direct investment (ODI) peaked at US$216.4 billion in 2016,but declined afterwards as the government tried to quell a round of “irrational exuberance” for offshore mergers and acquisitions. By 2018, China’s outbound investment was less than half of the total of inbound foreign direct investment. Nevertheless, outbound investment is rising again alongside China’s integration into the global economy. Equilibrium between ODI and foreign direct investment ultimately will be achieved,helping to balance the nation’s international payments position.

Learning from the Japan Experience

China can draw lessons from Japan in its “go global”campaign. The benefits to Japan from its program were substantial, including the improved competitiveness of domestic companies. Some economists like to focus on the downside of the “go global” campaign. They contend that China should resist US efforts to limit the depreciation of the yuan and that the 1985 Plaza Accord is a useful example of how policies can go wrong. They note that the agreement on joint market intervention to weaken the dollar against the yen and the German mark had a severe impact on Japan. They also point to the Japanese purchase of Rockefeller Center in New York in 1989 at a woefully inflated price as an example of the financial excesses that followed this agreement and resulted in the economic bubble and its aftermath known as the “three lost decades.”

But critics fail to take note of the fact that most of Japan’s overseas investments after the 1980s were profitable. In fact, Japanese companies stepped up their overseas investments over the last 30 years and gained major advantages as a result. According to the World Investment Report 2019 issued by the United Nations Conference on Trade and Development, Japan has been the world's largest overseas investor in recent years.In 2018, its profits from overseas direct investment hit US$143.16 billion. Additionally, it maintained a rate of return of around 6% on its overseas investments.Hence, the role of overseas direct investment in Japan’s economic development should be viewed objectively.China can gain valuable experience by encouraging its enterprises to take a bigger role in the global market.China can strengthen its bonds to the global industrial and value chains and advance its drive to upgrade domestic industry.

The effectiveness of international asset allocation can also be judged by the difference between the gross domestic product and the gross national product.Since the 1990s, GNP in many developed countries has surpassed GDP. This indicates that these countries have benefited from the growth in emerging economies,including China, by making investments in these markets.Chinese enterprises are expected to make similar efforts when they go abroad.Chinese enterprises are pursuing overseas resources and greater market share.With the help of efficient global allocation of assets,domestic companies will benefit from the strong growth of other economies.Correspondingly, China will see its GNP surpass GDP.

Market Linkage Programs

Through market linkage programs, including the Shanghai-Hong Kong Connect, Shenzhen-Hong Kong Connect and Bond Connect programs, capital has been able to flow between mainland China and Hong Kong under a managed framework. Despite fears from some quarters that capital flows will create new risks, the regulatory framework has actually contained risks with traceable transactions and capital flows.So far, the programs linking the mainland stock markets with the Hong Kong bourse have been the main channels for A-share purchases and sales. As of the end of June 2019, the net purchases under the two programs were valued at 427.4 billion yuan and 310.7 billion yuan,respectively. For domestic investors there are offshore investment instruments such as the Qualified Domestic Institutional Investor,Qualified Domestic Limited Partner and Qualified Domestic Investment Enterprise programs.

The Bond Connect program, which was launched in 2017, employs the settlement method of delivery against payment and this facilitates the participation of international capital in China’s interbank bond market. This program – along with the above-mentioned securities investment framework – have made it possible for China to be included in the FTSE watchlist in September 2018 and in the Bloomberg Barclays Global Aggregate Indices as of April 2019.

There is no denying that anti-globalization voices have grown louder in recent years.This is one of the factors behind the current Sino-US trade friction. But in order to deflect this protectionist pressure, it is necessary for China to open its financial market further and find ways to increase domestic demand.

China’s opening up of the financial sector has so far failed to keep pace with the steady expansion of overseas business by domestic corporations. This has in turn constrained the growth of the real economy and impeded the government campaign to achieve economic upgrading.China’s progress in opening the capital account slowed in 2016 due to stock market volatility and short-term pressure from the renminbi exchange rate. But the financial market turmoil of that period had its origins in the deficiencies of the country’s financial system. For example,the financial market lacked needed products and hedging instruments to offset shortcomings in market breadth and depth. That remains true today as well. It is therefore important for China to open the primary share market as well as derivatives trading and the foreign exchange market.

Macroprudential regulation and risk management are essential components of China’s reforms. If we compare emerging economies with developed countries that have made their capital account convertible, it can be seen that financial crises in more open economies occurred because of an unstable macroeconomy,a weak financial system and insufficient regulatory mechanisms. Drawing on these lessons, China is expected to strengthen its macroprudential regulation and supervisory mechanisms as it opens its financial sector. Reforms in capital account management will be conducted in a steady manner. Macroprudential and marketbased regulatory measures will replace administrative review. Additionally,quantitative instruments such as quotas will be reduced or scrapped, while pricebased tools, possibly including a Tobin tax,will be employed to adjust international capital flows.

Another critical step is to improve financial infrastructure in China. That will facilitate China’s inbound and outbound investment, and boost efficiency in asset allocation. For example, with the help of advanced technology, as well as supporting payment and settlement mechanisms, twoway capital flows — both online and offline— will benefit from timely and dynamic regulation.