Securities services, Macro markets
China’s balancing act
18 June 2021
China’s 14th Five-Year Plan for self-sufficiency has not stopped the country’s pursuit of renminbi internationalisation. flow examines the progress of the country’s ambitious capital market liberalisation reforms, and how it is balancing investor appetite with the management of currency inflows and outflows
Since opening up to foreign investment and trade in 1978, China’s GDP growth has averaged almost 10% per year.1 Fuelled by its accession to the World Trade Organization (WTO) in 2001, its transformation into a manufacturing powerhouse, and growing domestic consumption, the country is now only second to the US in terms of purchasing power parity. Behind these milestones are a set of unique weapons in a growing arsenal of economic prowess.
China has devoted significant resources to expanding its economy and global influence. Massive infrastructure programmes − such as the Belt and Road Initiative (BRI)2 launched in 2013 − are indicative of the country’s ambitions on this front. As at September 2020, the value of BRI projects totalled US$4.3 trillion.3 Although China has faced challenges – not least periodic bouts of stock market volatility and its strained trade relationship with the US – its economy is proving to be incredibly buoyant.
Covid-19 has provided a timely reminder of the country’s economic strength. Yi Xiong, Chief Economist, China, at Deutsche Bank Research, notes that had the pandemic not happened, China would have met its 6.5% growth target for 2016–2020 set by the Communist Party’s 13th Five-Year Plan (FYP), but only “by a very thin margin”. Actual GDP growth for the period averaged 5.77%. “China’s economy has proven to be extraordinarily resilient to Covid-19,” says Xiong. “Economic growth is now more dependent on internal consumption as opposed to demand for exports.”
In Xiong’s and Research Associate Grant Feng’s March 2021 white paper, China Macro: The 14th Five-Year Plan: 20 Targets for 2025, they note the FYP’s omission of average yearly growth targets, which were the centrepiece of previous editions. “Instead, it states that growth targets will be set each year, depending on conditions,” notes Xiong. “China is wary of committing itself when it does not know whether America will choke off its supply of high-end semiconductors, among other things.”
Although now less concerned with growth than self-sufficiency, China is pushing ahead with several ambitious market liberalisation reforms, as the country looks to internationalise the renminbi (RMB) by turning it into the reserve currency of choice for central banks. Greater international usage of the RMB, and providing foreign investors with more confidence in the currency, are offset by the necessity to maintain or even restrict currency inflows and outflows. This article examines how China is achieving this balance.
"Economic growth is now more dependent on internal consumption as opposed to demand for exports"
A market punching below its weight
The introduction and extension of cross-border platforms such as Stock Connect,4 Bond Connect5 and China Interbank Bond Market (CIBM) Direct6 over the past decade have enabled foreign asset managers to access China’s financial markets without the need to incorporate a local entity in the country. The result has been increased international flows into the Chinese equity and fixed income markets. For example, offshore investors increased their holdings of Chinese interbank market bonds by nearly 50% in 2020 to top US$500bn for the first time, according to Reuters data from 7 January 2021.
According to the China Foreign Exchange Trade System (CFETS) and National Interbank Funding Centre (a sub-institution directly affiliated to the People’s Bank of China (PBoC) that provides a series of services covering issuance, trade, post-trade processing, information, benchmark and training services for interbank foreign exchange (FX) market, money market, bond market and derivatives market), foreign holdings of Chinese bonds have grown at nearly 40% per year since 2017, reaching 3.25trn yuan (¥), or €417.8bn, at the end of 2020.
These market reforms have been instrumental in convincing a number of global benchmark providers, such as FTSE Russell and the Bloomberg Barclays Global Aggregate Index, to add Chinese debt to their indices. Despite these reforms, foreign investor participation in the onshore market continues to be somewhat restrained. Again, this is stifling Chinese efforts to internationalise the RMB. According to the International Capital Market Association (ICMA), China’s onshore bond market totals US$15trn, making it the second largest in the world after the US, but foreign investors hold just 3% of it (see Figure 1, below).
The value of China’s
onshore bond market
Tony Chao, Head of Securities Services, Greater China at Deutsche Bank, highlights several factors that explain why international investors were so underweight in Chinese bonds and equities relative to other developed markets. “China has historically been a restrictive market for foreign investors. Some global institutions have repeatedly expressed concern about repatriation risk and their ability to remit capital into and out of China,” comments Chao. “This often precludes Undertakings for the Collective Investment in Transferable Securities (UCITS) funds from investing in China, as UCITS rules state that managers cannot participate in markets where there are restrictions on capital flows.” In addition, the limited availability of FX hedging tools until 2020 was also off-putting for risk-sensitive investors.
To increase foreign participation in China’s bond market, the CFETS has worked on expanding the interbank market’s trading products and services to facilitate access. Meijing Li, General Manager of the RMB Market Department, sets out three key initiatives: “First, we are collaborating with third-party trading platforms such as Tradeweb and Bloomberg to enable foreign institutions to operate on a request for quote (RFQ) protocol from counterparties through their platforms or terminals via the over-the-counter CIBM Direct or Bond Connect channels. Second, we have introduced direct trading services under CIBM Direct, which allows foreign institutional investors to send quotation requests to domestic market-making institutions directly for spot transactions, and adopt the ‘international payment’ mode, which is more in line with foreign investors’ trading habits.”
“Third, we continue to facilitate trading by optimising pre-allocation, post-allocation and list trading functions, providing a full volume of indicative quotes on the bond market, lowering the minimum trading volume of RFQ to RMB10,000 (€1,285), and extending the trading hour to 20:00 Beijing time and settlement cycle to T+N. Lastly, the overseas issuance system (ePrime) provides one-stop electronic services for book entry and pricing and allocation of various types of overseas bonds, including Chinese corporate US dollar bonds and ‘dim sum’ bonds.”
Figure 1: Holdings of free-floating Chinese shares (%)
Source: Financial Times
As CIBM’s important central securities depository and securities settlement system, China Central Depository & Clearing Company (CCDC) provides a full set of bond services, including issuance, registration, depository and settlement for government bonds, local government bonds, policy bank bonds, enterprise bonds, and so on. It has deposited more than ¥77trn of bonds, accounting for about 74% of the total bond market. CIBM Direct is the main channel for foreign investors to participate in the CIBM. CCDC provides the CIBM Direct service for more than 1,200 foreign investors; these investors held ¥2.88trn of bonds by the end of 2020, accounting for 95% of the total amount of RMB bonds held by foreign investors. Among the bonds deposited by CCDC, the bonds held through CIBM Direct account for 76% of the market share (Bond Connect accounts for the remaining 24%).
Wenbin Zhou, Vice General Manager of CCDC Shanghai Headquarters, explains that “In order to provide better service to foreign investors to participate in the CIBM, CCDC adheres to the international rules, such as the Principles for Financial Market Infrastructures, to build an efficient and transparent segregated account system to fully protect their rights and interests. On the other hand, CCDC cooperates with the custodian banks to provide mature and convenient multi-level services for the market. For example, CCDC launched remote electronic account-opening measures to overcome the impact of Covid-19 by building online communication platforms for global investors to improve market transparency.
“CCDC also brought out several settlement facility measures, including a non-standardised settlement cycle and recycling settlement. Repo trade for foreign investors through CIBM Direct is also supported by CCDC (but is not yet applicable via Bond Connect). In addition, CCDC has established a connection with China’s futures exchanges to support investors who use their RMB bonds as margin in futures trading.”
Opening up of capital markets
Rules for international investors in China have also been simplified to attract further inflows. In September 2020, the China Securities Regulatory Commission (CSRC) confirmed that the Renminbi Qualified Foreign Institutional Investor (RQFII) and Qualified Foreign Institutional Investor (QFII) programmes would be brought together under one unified scheme, the Qualified Foreign Investor (QFI) regime, as of November 2020. This announcement came several months after the State Administration of Foreign Exchange (SAFE) abolished the QFII and RQFII investment quotas altogether.
Chao says the rule changes mean the application process for foreign investors has become more straightforward. “Before the QFII and RQFII reforms, it could take from six to nine months for international investors to set up an account. This was a major hindrance for investors. Now the application approval turnaround time has dramatically shortened, with an expanded group of eligible investors able to participate in the scheme.” Similarly, some of the complicated documentation requirements have been eschewed in favour of an online application form. Other entry barriers have also been removed, namely stipulations that investors have a minimum track record in terms of their operations and assets under management. Risk management controls were strengthened too, with qualified foreign investors now permitted to appoint as many custodian banks as they choose, having previously faced limits.
In addition to making it easier for foreign investors to access onshore Chinese securities, regulators are providing overseas institutions with access to a more diverse range of RMB investment products. Further to the on-exchange, cash bond and onshore FX derivatives markets, foreign institutions can now transact in shares traded on the National Equities Exchange and Quotations market; exchange bond repos; financial futures and commodity futures; options; margin trading; securities financing; securities trading; and private funds.
Chao predicts that the government’s decision to increase the number of available investment products will help generate foreign investor interest, especially from institutions that previously avoided China − citing a lack of investment choice, concerns about market liquidity, and an inability to hedge risk adequately. “We are seeing a growing number of long-term investors such as central banks and sovereign wealth funds express an interest in China,” explains Chao. “These reforms will be vital in attracting foreign investors and strengthening the RMB’s credentials.”
Figure 2: Projected asset growth in Chinese retail investor segments
Source: Deloitte Insights, China’s Investment Management Opportunity
A delicate balancing act
Given persistent volatility in the RMB’s exchange rate, it might become necessary for regulators to maintain or even restrict currency inflows and outflows, while still seeking to encourage greater international usage. As Xiong tells flow: “The regulator needs to preserve a balancing act where international investors are assured that if they have money in China, they can get it out without restrictions. From what I see, the PBoC is trying to manage this while gradually increasing exchange rate flexibility.”
To date, regulators have managed to achieve this balancing act. “The PBoC wants a more free-floating RMB as it will allow for more freedom and flexibility in terms of monetary policy,” says Xiong. “While some local companies that import or export may be worried about RMB volatility, I believe the central bank wants to gradually introduce a bit of volatility into the currency, and is keen for domestic corporates to learn how to manage currency volatility through hedging.”
"We are seeing a growing number of central banks and sovereign wealth funds express an interest in China"
Money going in
More international fund managers are beginning to launch Chinese onshore subsidiaries as they look to win mandates from the country’s burgeoning retail market, a demographic that Deloitte forecasts will make up US$30.2trn in investable assets by 2023 (see Figure 2, above).7 The ability of foreign fund managers to do this has been made possible by local regulators. Until recently, foreign asset managers looking to distribute products into China had to partner with a local securities provider, often through a minority-owned joint venture (JV). The wholly foreign-owned enterprise (WFOE) reforms announced in 2019 included a timeline for removing restrictions on foreign ownership of local asset management companies, putting an end to the JV requirement.
In April 2020, the CSRC accepted global asset managers’ applications for wholly foreign-owned fund management companies in China. Initially WFOEs were only allowed to target institutions, but China’s regulators have since confirmed they can also market to retail. This will likely prompt more global managers to establish WFOE private fund management companies in China, joining others such as Aberdeen Standard, BlackRock, Nomura and Fidelity who have already done so. “China’s population is getting older and its middle classes bigger, meaning there is an increasing demand for wealth management and investing,” adds Chao.
According to the Asset Management Association of China, assets under management in China totalled RMB56.17trn in Q3 2020, while 1,200 mutual funds were launched last year, accumulating a record RMB3trn.8 Research by the European Fund and Asset Management Association and the US Investment Company Institute also found that China overtook the UK, Australia and France in 2020 to become the fifth-largest fund domicile globally (see Figure 3, below).9
In addition, the European Union–China agreement on (direct) investment signed in December 2020 ensures that EU investors achieve better access to a fast-growing 1.4 billion consumer market, and that they compete on a more level playing field in China. The agreement includes conditions for market access covering areas such as manufacturing, the automotive sector and financial services. JV requirements and foreign equity caps have been removed for banking, trading in securities and insurance (including reinsurance), as well as asset management. In relation to providing a more level playing field, the agreement includes provisions stipulating that Chinese state-owned enterprises should not discriminate in their purchases and sales of goods or services.
Figure 3: Top 10 domiciles of worldwide fund assets (%)
Source: Financial Times (European Fund and Asset Management Association; Investment Company Institute)
Money going out
Since 2006, China has operated the Qualified Domestic Institutional Investor (QDII) scheme, a programme that enables domestic institutions to allocate capital offshore, albeit this is subject to quotas. SAFE data suggests that US$116.7bn in QDII quotas has been allocated since the initiative started.10
To further loosen capital controls, in 2020, China issued three separate QDII quota batches totalling US$12.72bn to financial entities such as banks, asset managers, insurance firms, securities companies and trusts.11
Facilitating inbound and outbound capital flows
Global banks with a licence to operate in China are facilitating these inbound and outbound flows. In December 2020, Deutsche Bank received its domestic fund custody licence from the CSRC, enabling it to provide post-trade services and other solutions for funds established in China, including WFOEs and the domestic asset management industry.
Following the QFII and RQFII changes, global banks are also facilitating offshore investors’ access to new, onshore investment products. In December 2020, Deutsche Bank successfully facilitated a margin trading and securities borrowing transaction under the new rules, on behalf of a major QFI client. “Deutsche Bank’s global network makes it easier to support cross-border investment flows,” explains Chao. “Not only can we help domestic investors with their overseas requirements, but we can also support offshore clients when accessing China too.”
China: the recovery starts here
As many countries continue to grapple with Covid-19, China is one of the few that has successfully limited its impact. Liberalising measures and a balanced approach towards enabling inward and outward investment are having their intended effects. Assuming these policies continue, it may not be long before the RMB is fully internationalised and becomes a key central bank reserve currency and major settlement currency.
As the country forges ahead with its 14th Five-Year Plan, which was unveiled in March 2021, its future dependencies on global markets may look different in 2025 compared to 2001, when the country joined the WTO. One thing that is clear, however, is that in the race to economic recovery, foreign investors will be looking very closely at this promising market. At the same time, the growing wealth of China’s domestic population should prompt more external investment as the rules around how citizens invest are further relaxed.
1 See https://bit.ly/3hkW5Nt at worldbank.org
2 See China’s Belt and Road Initiative - A guide to market participation at corporates.db.com
3 See https://bit.ly/3oeqRsR at scmp.com
4 See https://bit.ly/3oDgcbo at hkex.com.hk
5 See https://bit.ly/3tHxzsE at chinabondconnect.com
6 See https://bit.ly/3tJ2dBY at simmons-simmons.com
7 See https://bit.ly/3ya2MI7 at deloitte.com
8 See https://bit.ly/3ffki6y at db.com
9 See https://on.ft.com/3vX3aIa at ft.com
10 See https://bit.ly/3bmoHC8 at fundselectorasia.com
11 See endnote 10
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