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Opening Up China's Markets Won't Be Straightforward

  • More accessable markets helps China balance outflow pressure
  • Easing rules for investing has accompanied outbound clampdown

China’s recent policy of opening its markets to foreigners is expected to continue this year, but there are questions about how meaningful the change will be amid a clampdown on money leaving the country.

While China loosened restrictions on its interbank bond market and relaxed rules for offshore investors trading stocks, it also saw $762 billion head overseas in the first 11 months of last year, according to Bloomberg Intelligence estimates, as investors sought safety in foreign assets. That helped push the yuan down 6.5 percent against the dollar in 2016, the most since 1994. Seeking to stem the flow, mainland authorities tightened rules that contributed to MSCI Inc. refusing to add Chinese-listed shares to its global indexes.

China’s regulators have indicated that this year foreigners might be allowed to access commodity futures and bond derivatives, while MSCI will again consider adding mainland stocks. But concerns remain about how open China’s markets will be, especially on the issue of taking assets out of the country. The contrast highlights the tension authorities face between inviting more investment while keeping control of the financial sector.

“I’d describe China’s strategy as a pipeline strategy. Essentially what they do is to create various pipelines of inflows and outflows,” said John Greenwood, London-based chief economist at Invesco Asset Management. “The problem is the flows are always in the opposite direction of what they want.”

Among last year’s steps, Beijing lifted almost all quotas on China’s interbank bond market and scrapped some constraints under the Qualified Foreign Institutional Investor program, which governs how offshore funds invest in mainland markets. The Shenzhen-Hong Kong stock exchange link, the second between the mainland and the former British colony, opened in December.

Expectations then rose as an official with the People’s Bank of China said the central bank is committed to further opening the interbank market, including giving foreign investors access to foreign-exchange and interest-rate derivatives to hedge risks, and expanding trading hours.

Open and Close

Even as China opens up to incoming funds, it has been clamping down on outflows. Officials have banned the use of friends’ currency quotas, made it more difficult to buy insurance policies in Hong Kong and prepared restrictions on overseas acquisitions by Chinese companies. Grants of new quotas for domestic fund managers to invest overseas were frozen, according to data compiled by Bloomberg.

The tightening of outflow rules makes it hard for some to say that the country is fully embracing financial reform.

“We have already seen in China’s case, markets only work when they go up. You are not allowed to go down,” said Michael Every, head of financial markets research at Rabobank Group in Hong Kong. “If we do get any reforms this year, they are going to be Potemkin reforms. The veneer will look like they are moving to a market economy, and the reality will be anything but.”

China has studied possible scenarios for the yuan and capital outflows this year and is preparing contingency plans, Bloomberg News reported, citing people familiar with the matter. Financial regulators have already encouraged some state-owned enterprises to sell foreign currency and may order them to temporarily convert some holdings into yuan under the current account if necessary, according to the report.

Concerns about the difficulty in taking assets out of the country were one of the reasons stated by MSCI in June when it declined, for the third straight year, to add China’s domestic stocks to its benchmark indexes. The decision was a blow to China’s hopes for better integration into the global financial system and came at a time when it needs funds to stabilize its currency. Analysts have estimated that inclusion could mean as much as $30 billion of inflows from foreign fund managers.

The Shenzhen-Hong Kong link, which was accompanied by the removal of total aggregate quotas -- though daily quotas remain -- is one way China is addressing the trading difficulties flagged by MSCI.

“It’s still hard to predict at this stage what the MSCI decision would be this year,” said Castor Pang, head of research at Core-Pacific Yamaichi in Hong Kong. “The Shenzhen-Hong Kong Connect helped a little, but issues remain on the trading limits and the constraints on moving money out of the country.”

Bad Timing

Further easing of China’s market rules, and even MSCI inclusion, may come at a time when interest in the mainland has cooled. The benchmark Shanghai Composite Index fell 12 percent in 2016, its worst annual performance since 2011.

In recent years, the shine has come off of China’s economy after decades of super-charged growth slowed to its weakest in a quarter of a century. While the economy is on track to meet the government’s target for expansion, analysts warn that stability has come at the cost of a growing debt pile.

“Asset returns in China have been, and will be, declining amid the slowdown in economic growth,” said Chen Yalong, a Shanghai-based strategist with Northeast Securities Co. “So the opportunities for foreign investors would be structural.”

Still, there may be hope for those who are willing to take advantage of the expected loosening.

The Shanghai Composite Index will climb to 3,800 by the end of the year, a 22 percent gain, according to the median forecast in a Bloomberg poll of 12 strategists and fund managers. A stabilizing economy, faster spending on infrastructure and recovering earnings growth were among factors seen driving gains in the nation’s shares, the survey showed.

Those hoping to benefit from that growth should enjoy this year’s expected easing of restrictions, though it may be some time before China’s markets are fully open.

“The liberalization of the capital markets in China is an aspiration rather than a concrete policy goal,” said Greenwood. “I think as long as you have controls on the balance of payments, they’re not going to have a fully open domestic market.”

— With assistance by Gary Gao

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