China Further Opens Its Financial Sector To Foreign Firms

TO ANYONE WHO has been paying attention, Friday’s announcement by Deputy Finance Minister Zhu Guangyao of foreign firms being allowed broader access to financial markets would not have come as a great surprise. The move has been steadily if quietly signalled for some months.

Among those not paying attention appears to have been US President Donald Trump. His administration’s published summary of his accomplishments on his state visit to Beijing this week makes no mention of it. This stands in contrast to the much trumpeted $250 billion package of already agreed exports and memoranda of understanding for future sales that may or may not materialise as hard orders for US manufacturers.

To this Bystander, the contrast is emblematic of a visit for which the US president left the China hawks in his cabinet at home in favour of the company of a US trade delegation, and during which he quite unpredictably blamed his predecessors for US trade deficits with China, not the predatory trade practices of his hosts that he had lambasted on the campaign trail last year.

Our equilibrium was only restored when Trump returned to his ‘America First’ trade bashing of China and its regional fellows at the APEC summit in Vietnam. When it comes to international trade, Trump is clearly more a goods than services sort of guy, but then he has to deliver industrial jobs to supporters who perceive themselves as the losers of liberalised global financial markets.

Perhaps the oversight was also because the financial market opening applies to all, not just US firms. Yet it is US firms that have been at the forefront for years in pushing for greater access to China’s financial markets.

Friday’s announcement means that US and other foreign financial firms will be allowed to own 51% stakes in certain financial joint ventures, lifting the proscription against foreigners holding controlling stakes in Chinese commercial banks, investment banks and securities firms, fund managers and insurers.

Ownership caps have made foreign firms marginal players, even though foreign investors have had growing access to China’s equity and bond markets. The likes of Citigroup, Goldman Sachs, Deutsche Bank, UBS and others have been so discouraged hitherto (or in some cases so cash-strapped) that over the past decade they have sold their minority stakes in the sector that were acquired from the mid-2000s onwards after the restructuring of China’s banks in 2004-05 and the opening of financial markets in 2006 in accordance with China joining the World Trade Organisation

HSBC is the only international bank to retain a significant stake — 19.9% of Bank of Communications acquired in 2004. In all, foreign banks held 2.9 trillion yuan ($436 billion) of assets in China at the end of 2016. That accounts for 1.3% of China’s total banking assets, the lowest share since 2003, according to the China Banking Regulatory Commission, and down from a peak of 2.4% in mid-2006.

These assets returned a relatively trifling 12.8 billion yuan last year, less than 1% of the profits at Chinese counterparts.

From such a small market share there is self-evidently room for growth. Commercial lending looks the least attractive area. State-owned banks dominate the financial system. Their close links to the state-owned companies that drive much of China’s economic activity will be difficult to break. Slowing economic growth and growing credit risks also cloud the outlook for commercial banking.

Instead, foreign firms will focus on increasing their presence in insurance, investment banking and fund management. All have better growth prospects.

The devil, however, is in the details. Regulators are still drafting detailed rules, which will be released soon, but three-year and five-year timelines have already been set out for the implementation of some of the changes.

For example, the foreign ownership cap for life insurance companies will be lifted to 51% after three years and scrapped altogether after five. The same two-stepped approach is being taken towards securities and fund management companies, though in their cases the caps will be gone within three years of the new rules becoming effective (itself still not a date certain).

The gradual timelines and broad official support for this phase of financial-market liberalisation should mean it goes relatively smoothly, and give local firms the time to sharpen their game.

That is a key official priority. Within the central bank, at least, there is a view that protection of local financial firms is a source of financial instability risk. Along parallel lines of thinking, a more professionally skilled industry should also help with the official efforts to deleverage and rein in the shadow banking system.

The changes will no doubt bring in more financial management expertise and global standards of governance, along with more foreign capital investment which will be needed as China continues to drive its economy up the value-added chain. The slowing rate of inward foreign direct investment is a concern.

In this regard, we shall also be watching to see if the Party seeks to exert its control over foreign financial firms in the same way it is doing with commercial ones, especially in the name of fighting corruption.

The new moves suggest, too, that the deadlock between various ministries that has held back financial market reforms has been broken. That may lead to some eventual progress on the far more controversial internationalisation of the currency, full convertibility of the exchange rate and opening of the capital account.

These all still await and will do for some time, probably until this phase of market opening is complete, though we may see draft timetables over the coming months stretching into the 2020s.

Beijing’s Devaluation Dilemma

 

THE CLOCK IS ticking down on the inauguration of US President-elect Donald Trump and thus on Beijing’s decision about if and how to devalue the renminbi. China is caught between an exodus of capital and whatever hawkish policies against it that a Trump administration could bring.

The renminbi fell 7% against the US dollar in 2016, in its biggest fall since 1994. Most of the fall occurred in the fourth quarter as the US Federal Reserve started to raise interest rates.

The case for a one-off step devaluation is that it would, assuming it was large enough, staunch the outflows, and end the need to run down the foreign-exchange reserves to defend the currency. The case against is that Chinese companies with dollar-denominated debt could be put in peril, importers would face a squeeze on margins and Trump’s strident accusations of China being a currency manipulator to support its exporters by undervaluing the renminbi would gain more credence.

Also, a Chinese devaluation could set off a round of competitive devaluations by emerging economies that would rock the world economy. There is ‘previous’ in this regard. Beijing’s unexpected devaluation in August 2015 caused global shockwaves.

At the same time, China’s foreign exchange reserves, being used, regardless of Trump’s claims, to prop up the currency through market intervention, are being eroded. While comfortably large at more than $3 trillion, even they cannot be run down indefinitely. The People’s Bank of China has already used $1 trillion of the reserves to defend the currency, taking them in December to their lowest level in six years.

And what probably matters more is investor sentiment. To that end the central bank earlier this month orchestrated liquidity squeeze in the offshore market in Hong Kong, to make it more expensive to bet against the renminbi, a signal intended equally to be read in the onshore market.

As the devaluation debate rages among policymakers, Beijing has been putting administrative measures in place to reduce the outflows. A stop has been put to the dodge of using investment-linked insurance policies in Hong Kong both to move savings overseas and switch into dollars. The level at which banks are now required to report all yuan-denominated cash transactions has been lowered to 50,000 yuan from 200,000 yuan.

The individual annual quota of $50,000 in foreign currency is unchanged, but citizens are being asked for more detailed information about why they need the cash;  tourism, business travel and medical care and education overseas is looked on favourable, but not purchases of overseas property and financial assets.

Similarly, a closer eye is being kept on Chinese firms foreign direct investment, especially M&A involving real estate, hotels and cinemas. Bitcoin exchanges, which account for 95% of global trading in the crypto-currency, are being leant on to stop a backdoor way to cash out of the yuan. There is even speculation about a crackdown on the excessive transfer fees Chinese football clubs are paying to bring in foreign stars.

In this environment, state-owned enterprises are likely to be leant on to repatriate foreign currency earnings held offshore while foreign firms will find it harder to repatriate their profits.

All of this flies in the face of policies to internationalise the currency that have been persued for some time, and whose continuance was implicit in the IMF’s adding of the renminbi to its basket for Special Drawing Rights last October.

The other conventional prop for a currency is higher domestic interest rates. However, with more than 1 trillion yuan of corporate bonds due to mature every month from now until the third quarter of this year, higher rates would impose a massive refinancing burden on companies.

Also, it is far from clear how much strain higher rates would put on the shadow banking system and what the spillover would be to the rest of the financial system, but the sense is that it is a significant risk.

That leaves devaluation — gradually or in a one-step change — as the most likely option.

In a sense, that is inevitable. Dollar strength globally is probably a bigger factor than renminbi weakness. Last month, however, that did not prevent Trump tweeting, “Did China ask us if it was OK to devalue their currency?” Nor is it likely to do so again.

Financial policymaking is difficult at the best of times, never more so than at a time of unpredictability — and with a clock ticking.

The Renminbi Ups Its Status

THE INTERNATIONAL MONETARY Fund added the renminbi to its basket of Special Drawing Rights (SDR) currencies at the start of this month, thus officially marking it as a member of the elite club of global reserve currencies. It is a membership of which China has long been desirous.

The IMF had decided last November that China could join at the next scheduled SDR review, and that it would constitute 11% of the basket. That gives it the third largest share, behind the dollar and the euro but ahead of the other member currencies, the yen and sterling.

Weightings are meant to reflect the use of a currency in trade and the financial system so China may have been treated generously in this regard. It share of global payments, for example, peaked at 2.8% last year and is below 2% now.

Joining the SDR basket is, at this point at least, as much symbolic as anything, an acknowledgement of the global weight of China’s economy, and encouragement to push ahead with the financial reforms that would make the renminbi the freely usable and widely adopted currency that IMF reserve currencies are meant to be.

That, in turn, would promote more foreign interest in yuan-denominated assets, particularly bonds. Central banks and sovereign wealth funds will, however, build up their renminbi-denominated holdings only gradually.

Looking back in a decades time, though, the change may look more momentous, both if China’s financial markets become deeper and more liquid or it turns out that the renminbi was just the first of several emerging market currencies (India’ rupee is another candidate) to find a place in the SDR basket.

China’s Currency Depreciation Is Not An Opening Salvo In A Currency War

HAVING SIGNALED AS recently as late last month a widening of the yuan’s trading band, authorities have opted for a ‘one-off’ devaluation of the currency. The People’s Bank of China on Tuesday set its daily fix 1.9% lower than the previous day, its biggest daily shift since introducing the system, and taking the currency to a three-year low.

At the same time, the central bank said that future fixes would pay more heed to both the previous evening’s closing price and movements in the foreign-exchange markets. It will also seek to drive closer convergence between on- and offshore exchange rates.

This Bystander retains the view that these changes are primarily steps in the direction of eventual full convertibility of the yuan rather than a ‘currency-wars’-sparking devaluation to bolster exports and thus boost the slowing economy. Rebalancing the economy and securing IMF SDR status remain higher policy and propaganda priorities. Both require liberalised foreign-exchange markets.

As the chart above shows, the currency has been moving modestly lower against the dollar since the beginning of last year having seen a steady appreciation for the previous eight and a half years. However, as the chart also shows, the central bank has been holding a lid on that depreciation most recently, probably for fear of destabilising capital outflows.

In the short term, the central bank’s unexpected policy change will likely let the currency drift lower than it would otherwise have done. But the key point is that depreciation — and its reversal if and when it comes — will be driven more by market forces than administrative fiat.

China May Let Its Currency Drift, But It Is Not About To Fight A Currency War

THE STATE COUNCIL last week proposed some measures that suggest to some that China is ready to indulge in bald-faced competitive devaluation to boost exports and thus growth—even if it did not cast it in those terms.

The Council said that the People’s Bank of China should widen the daily band within which the renminbi can trade on foreign exchange markets. This Bystander recalls that the last time the State Council weighed in on the subject in public, in March last year, within a fortnight the central bank had expanded the permitted trading range to 2% either side of the mid-point it sets from 1%.

If history is prologue, that will open the way to a devaluation of the currency that authorities might be happy to encourage, manage or manipulate — you choose your description. That would represent an escalation from the general monetary easing policies the central bank has been following for many months.

That, at least, is one argument that is being made. However, the opportunity to devalue the currency and the will do so are not one in the same.

Furthermore, even those forecasting a devaluation have to answer two essential questions. First, how sharp would any devaluation be? Second, would it be sufficiently large to encourage retaliation particularly from regional trading partners — though some Chinese exporters may feel that Japan, in particular, has already got its retaliation in first having seen a 30% devaluation of the yen in the era of Abenomics?

However, exporters are not the ones making the decisions, and, arguably, their domestic political clout over such decisions is at its lowest ebb in many a year.

The policymakers who will be making the decisions about the currency know that boosting exports to goose growth is just as old-school a stimulus as infrastructure investment spending and undertaken to the detriment of rebalancing. That remains the greater policy priority.

China’s foreign-exchange regime has its part to play in that. It may not be a leading role, but equally it is not a solo performer.

For that reason alone, we expect any devaluation brought about by a widening of the renminbi’s trading band to be slight, more a downward drift than a devaluation. Moreover, any sharp weakening of renminbi could trigger capital flight at a time when the financial system is not in the best of shape to weather it.

Making The Half Empty Glass of Financial Reform Go Away

THAT CHINA’S FINANCIAL system is “unbalanced, repressed, costly to maintain and potentially unstable” will not brook many arguments among policymakers in Beijing. It is, after all, why they are deep into an extensive programme of financial reforms, reforms that are seen as central to the long-term rebalancing of the economy.

It is also why “a weakly regulated shadow banking system” and a tendency of “wasteful investment and over-indebtedness” that is the consequence of a “traditional investment-driven growth model shaped by heavy state intervention” are also being tackled as policy priorities.

However, it is one thing for officials to know that and quite another to have it told to them publicly by the World Bank.

The phrases quoted above were all contained in a section of the Bank’s latest China Economic Update, published mid-week, which called for a quickening of financial-sector reform. The entire section has now been removed from the update, because, the Bank says, “it had not gone through the World Bank’s usual internal review and clearance procedures.”

Whatever, this Bystander is tempted to say. Any red faces at the Bank are probably due as much to the tongue lashing that would have come from Beijing as from the embarrassment of having to redact a section of a report post-publication.

With share prices on the Shanghai exchange in meltdown and the signing ceremony earlier this week setting up the Asian Infrastructure Investment Bank (AIIB), a putative rival to the Bank’s regional clone, the Asian Development Bank, and longer term to the Bretton Woods’ multilateral institutions as a whole, there could be some understandable sensitivity on both sides. Also, China readily takes public offense at any perceived criticism by any institution seen to be in the pockets of the U.S. and the EU — and the World Bank has previous in this regard.

What, to our mind, lies behind this particular spat is that when the International Monetary Fund comes to consider in October whether to endorse the renminbi as an official reserve currency by including it alongside the dollar, sterling, euro and yen in the basket of currencies that comprise its Special Drawing Rights, progress on China’s financial reform — and particularly whether renminbi interest rates are market-based — will be a key criterion.

The IMF reviews the components of its SDRs every five years. It would be an unwelcoming rebuff for China, which is being ever more assertive in claiming its place at international top tables, if it were made to wait until 2020 for inclusion.

As recently as March, Prime Minister Li Keqiang told Christine Lagarde, the IMF’s managing director, that China intended to speed up the financial sector reforms needed to meet the stringent requirements of stability and liquidity demanded of a reserve currency.  With IMF staff preparing their internal assessments for the 2015 SDR review around now, this is not a time when Beijing will brook any public plain-speaking about the pace of financial reform.

China’s Central Bank Takes A Swipe At Speculators

CHINA’S CENTRAL BANK has been acting out of character this week — or at least out of recent character. It has surprised and alarmed investors by unexpectedly pushing down the value of the yuan against the dollar and easing its tight grip on money markets. Its goals, this Bystander assumes, have been to take another shot at the speculators who still see the appreciation of the currency as a one-way bet, and to ease the high interest rates that continue to attract hot money.

Hard-pressed equities and real estate investors won’t be sorry to see rates easing either. Nor will the shadow banking system nor highly indebted state-owned enterprises. All of which might make for a more welcoming backdrop to the annual session of the National People’s Congress due to start shortly.

However, juicing the slowing pace of growth and forestalling any unseemly defaults in the financial system while lawmakers are gathered comes at the price of suspending the central bank’s effort to let down the country’s credit bubble and deleverage systemic financial risk. That, though, cannot continue for too long if the bigger goal — rebalancing the economy towards greater growth from consumption and away from exports and infrastructure investment — is to be pursued.

London Expands As Offshore Yuan Center

Last year, the British and Hong Kong governments agreed to promote London as a center of trading offshore yuan. This week, some meat was put on the bones of that agreement with the issue of a three-year yuan-denominated bond in London. HSBC was the lead on the deal, the first so-called dim sum bond to be issued outside China. It raised 2 billion yuan ($317 million), mostly from European investors, and yields 3%. Demand from investors was so heavy that HSBC doubled the bond from its originally planned size.

Yuan-denominated deposits in London totaled 109 billion yuan at the end of 2011, according to a report commissioned by the financial district’s government and published to coincide with the launch of a working group to develop London as the western hub for offshore yuan business. The group includes HSBC, the biggest issuer of dim sum bonds in Hong Kong, and Bank of China.

London’s is a sufficient pool of liquidity to start supporting a bond as well as a foreign-exchange market, but it is still less than a fifth of the 566 billion yuan in renminbi deposits in Hong Kong as of February. Despite the strong push London is making, Hong Kong remains the leading offshore yuan market, as Beijing desires. Singapore and New York also have designs on the business but London has stolen a march on them.

China’s doubling of the yuan’s trading band and other recent financial reforms, including allowing banks to hold short dollar positions, raising the ceilings on foreigners’ equity and bond investments in China, and a trial of giving domestic Chinese investors more access to offshore yuan markets, are all part of Beijing’s drive to expand the international use of its currency that started in 2008. More optimistic financial reformers have pencilled in 2015 for full convertibility. The more cautious fear that would be a destabilizingly quick timeline, especially if GDP growth continues to slow.

If the on- and offshore interbank markets forge a close link, that could force the pace. However, the offshore market is still in its infancy. Baby steps are yet to be made. In June, Hong Kong plans to extend its yuan payments trading to overlap with London hours. For its part, London is working on setting up local yuan clearing and settlement systems, probably piggy backing off Hong Kong’s. More European banks are expected to follow HSBC’s lead in issuing dim sum bonds in London later this year, as are the Agricultural Development Bank of China, China Development Bank and the Export-Import Bank of China.

Other yuan-denominated investment products will likely follow. But how fast London, or any other financial center, can develop as a hub of offshore yuan trading, will ultimately be determined by how quickly Beijing opens its capital account and lifts its foreign exchange controls so there is a sufficient volume of internationally circulating yuan to support the business. At present for every yuan deposited outside China, there are 99 inside.

Beijing’s Currency Wars Playbook

Beijing will play its usual defense against the moves in the U.S. Senate to twist China’s arm to appreciate its currency against the dollar: vociferous denunciation of Washington for turning protectionist and initiating “trade wars” while patiently waiting out the start of any serious hostilities, calculating that the threat of them will eventually recede.

The denunciation has duly come with Foreign Ministry spokesman, Ma Zhaoxu, saying the bill now in front of the U.S. Senate proposing punitive measures against any country that is shown to be manipulating its currency — for which read China — “seriously violates rules of the World Trade Organization and obstructs China-U.S. trade ties”. He told U.S. Senators to abandon protectionism and stop politicizing economic issues. He also told them to “stop pressuring China through domestic law-making”. Co-ordinated sentiments have been expressed by the central bank and the commerce ministry.

While perhaps nobody outside the U.S. Congress really believes that a sharp revaluation of the yuan on its own will eradicate America’s trade deficit with China or create the new domestic jobs the U.S. is having such trouble generating, Beijing will know that even if the Democratic majority in the U.S. Senate passes the bill, the legislation will likely founder in the Republican controlled House of Representatives. Even if it does not, it is highly unlikely to survive a presidential veto. That is the past pattern of such proposed legislation. Support for this year’s bill appears to be stronger, helped by its narrower provisions and the background of sluggish U.S. growth and joblessness, but the odds remain long that it will become law.

At the very worst from China’s point of view, and the bill does become law, it will be cheaper politically for Beijing to fight any punitive measures through the WTO than it would to be seen to capitulate to foreign pressure. Meanwhile, it can bide its time, letting the gradual appreciation of the yuan that has been underway since June last year (up 7% against the dollar since then and 10% against the euro) ease the U.S. pressure, which is anyway likely to abate after next year’s U.S. elections. Simultaneously, it buys more time for the economy, particularly the export-manufacturing sector, to adapt.

China’s policymakers are quite happy for the yuan to appreciate. It will help them both fight inflation and restructure the economy. They just want do it to their timetable, not Washington’s–and they have the playbook to do that.

China’s Policymakers Smile On A Stronger Yuan

China’s policymakers may not be too sorry, for once, to see the yuan hit its highest value against the U.S. dollar since 1993. This week alone has seen the currency rise 0.7% against the greenback, its largest weekly jump in four years. By the standards that Beijing has imposed on the tight management of its currency, and its resolute opposition to letting the yuan appreciate except to its own timetable, it is a dramatic rise.

Long-term, it has always been in China’s interest (and policymakers’ plans) to let the currency appreciate towards market-driven levels in order to support the effort to reorient the economy away from export-led growth and towards domestic consumption. But a number of short-term factors have come together to make a stronger yuan desirable now.

It will help in the fight against inflation, which hit a three year high of 6.5% in July. It will slow the accumulation of dollar-denominated foreign-exchange reserves at a time when Chinese officials worry about the erosion of the their value in the face of the U.S. deficit debacle, and July’s trade surplus, the largest in two years, will swell them further. It, up to a point, would also pre-empt further inflationary impact on China of a further round of quantitative easing in the U.S., should the U.S. Federal Reserve may good on some hints that that might be necessary if U.S. GDP growth remains tepid, and, even more intangibly, it stocks up some international goodwill for Beijing as it makes China look to be a responsible team player in the face of a potential ‘double-dip’ global economic slowdown.

Most important of all, as far as the internal debate on the currency goes, appreciation would not be happening in the face of foreign, particularly U.S., pressure to let it happen. Whether there is a fundamental shift towards liberalizing China’s exchange rate policy about to happen, or, as seems more likely to us, a cautious step in that direction through, say, widening the bands within which the yuan is allowed to fluctuate each day, it won’t come without some cost to the rest of the world. The dollar, by definition, would fall and U.S. Treasury yields rise, if not disruptively; China would export some of its inflation. Many of these effects would, of course, net out across the global economy, such is the arithmetic of current accounts. How smoothly that would go depends as much as anything on what progress China can make in liberalizing its domestic financial markets. That is the biggest missing piece in making the arithmetic of canceling out the global imbalances work out.