Continued Acceleration of the Reform of China’s Capital Markets Still Needed

The equity market is the most developed of the capital markets in China. Nevertheless, solving the many practical barriers to the development of both listing and trading is essential if China is to balance liquid, transparent markets with less volatility in its equity market. This is in the interest of all investors (domestic and foreign) and for China’s economy. Utilizing advances in technology, in which China is already a leader, to make its markets more efficient, along with proper supervision, further integration, and alignment with global markets, is paramount to growing China’s role as a world leader.

A good example of this is the Shanghai Stock Exchange’s launch of a registration-based STAR Board listings regime for innovative technology companies, coupled with more market-friendly trading rules including stock borrowing and lending. The Shenzhen Stock Exchange followed suit by revamping its own renovated Chinext listings regime in line with Shanghai’s. Both are good examples of reforms taken to support more efficient capital raising for the most dynamic companies in China, fueling the growth generators of the economy. The registration-based listing regime should be further extended to the broader market on both exchanges to replace the long regulatory approval process for new listings, which slows down companies’ ability to raise capital and would hamper the economy.

China equities now account for 40% of MSCI’s Emerging Markets index series, 5% from A shares, and the other 35% from Chinese securities listed on other exchanges (HK, US). On the A share front, the current 5% represents a 20% MSCI Inclusion Factor (accounting for only 20% of China’s overall market capitalization); as China continues with market reforms to facilitate easier access for global investors, there is potential for the A share component to increase five-fold to 100%.

To facilitate greater QFII/RQFII participation in China’s equity markets through Stock Connect, QFII, and index inclusion increases, it would be helpful to align with global standards in areas including the following:

China’s fixed income market, which is now at USD 18 trillion and the second largest in the world behind the USA (USD 40trn), has seen an almost 50% increase over the past two years. China has become a world leader in the ‘green bond’ market as issuance has soared to about USD 190 billion as of the end of 2020 from less than USD 1.0 billion at the end of 2014. With 56% of the market instruments issued by government-related entities, the corporate bond market is much smaller than in major competing economies, mainly due to its high reliance on loans—proportionally 50% more than in the USA. Moreover, while the bond market is large, the liquidity in the secondary market is rather poor for its size. To better allocate capital to dynamic and healthy companies that will contribute to economic growth, China needs to continue to move away from the opacity of the loan market—where funding may be allocated based more on relationships or other factors such as a firm being a large local employer- and incentivize corporate issuances where investors can properly assess the credit risk of issuers. To achieve this, a number of steps need to be taken. The most important is establishing and allowing an independent credit rating system with an appropriate scale of differentiation between high- and low-quality corporates. This can hardly be possible today when 89% of the Chinese corporate and enterprise bonds are rated AAA and AA (compared with 7% of the US corporate market). When companies get into trouble, particularly state-owned enterprises, they should be allowed to default and not have the government intervene. Since 2018, there has been an increase in defaults, which is a sign of a maturing market and will lead to re-basing of credit risk.

To improve credit risk analysis, foreign rating agencies need to be recognized and allowed to rate all bonds and ensure a level playing field with their local competitors. The regulators should encourage further alignment of domestic ratings, together with information disclosure and due diligence processes, to international standards and best practices.

Improving the secondary market liquidity is another important factor for investors so that they can confidently and easily enter and exit the debt capital market without having to hold every instrument to maturity.

The derivatives market also needs to be further developed to allow market makers and investors to appropriately hedge their risks against interest rate, market, and credit risks, which ultimately benefits price discovery and lowers funding costs while optimizing resources allocation.

Bond futures are the most important listed derivative product, but lack liquidity. The big five domestic banks sit on the bulk of the underlying government bonds, but to date have not been accessing the futures market directly even though it has been legally permitted since early 2020.

To further develop liquidity and provide hedging instruments to a broadened participant base on a level playing field with their peers, direct access to more domestic institutions and international investors through QFIand Chinainterbank bond market (CIBM) Direct channels must be permitted.

Interest rate swaps are relatively liquid, but floating reference rates are not aligned with corporate financing reference rates. There is limited recognition of ISDA documentation versus NAFMII documentation, which bifurcates the foreign and domestic derivatives markets and thereby undermines liquidity.

The other cornerstone in the fixed income markets is a well-functioning repo market where sellers can lend securities to buyers, who can, in turn, trade them in the market, providing liquidity to investors. Contrary to global standards, the securities are pledged in China and do not have their ownership transferred which prevents rehypothecation—hence reducing liquidity—and creates risks in case of counterparty default or bankruptcy. There is also no tri-party repo, an important feature needed to encourage bondholders like insurance companies, pension funds, etc. to finance or lend those securities, although we know the CCDC is working on a solution. With respect to foreigners, who are more familiar with repo, it would make sense to allow them to access this market via any channel and not just QFI, as it stands now, and to use the globally recognized GMRA master agreement rather than the local NAFMII documentation.

For both derivatives and repo to work well, close out netting needs to be officially recognized in China preferably through a legislative change at the State Council level; otherwise, these capital-intensive instruments will bear significantly increased costs.

Finally, as global fixed income markets are dominated by institutional investors, the size of their participation—both domestic and foreign—needs to increase dramatically. One big regulatory change would be to lower the statutory liquidity requirement on banks to hold government bonds so that insurers, pension funds, asset managers, etc. can be lured into the market. Regulators should also consider broadening the range of fixed income products for retail investors through bond ETFs or funds, which could partially unlock the large retail bank deposits (USD 32trn) as a potential source for future development.

Currently, limited FII participation (3.2%) is mainly focused on government bonds and is very small compared with other large bond markets. There has been growing interest around bond index inclusion following the FTSE Russell announcement. To encourage further FII participation, the various access channels can be further streamlined (see below under market access). There is also a need for an overall tax exemption reform or clarification (e.g. extension of the tax exemption for FIIs expiring in November 2021 from VAT and withholding tax on interest and widening of the scope of eligible debt securities to asset-backed notes, asset-backed securities, and certificates of deposits, FX capital gains on repatriation) to bring China in line with other markets. Finally, there is very limited use of RMB as an international currency (1.16%/1.88% according to SWIFT). USD remains the key currency for international trade and financing, including for BRI projects. Accelerating capital account and foreign exchange reforms would support the adoption of the currency for both financing and investment. This is a good segue into our next topic.

The FX market is the world’s largest financial market. Effective and efficient exchange of currencies underpins the world’s entire financial system. The FX market is also the basis of the global payments system. The volume of transactions is, therefore, very high, and these transactions are often executed by market participants across geographical borders.

China first indicated its intention to internationalize the RMB and decouple its dependency on the USD in the early 2000s. This accelerated in the period after the financial crisis as China started to recognize the risks inherent to their reliance on the USD. As part of this effort, the PBOC announced in 2005 that it would adopt a managed floating exchange rate system in which the daily fix for the exchange rate was to be determined by referencing a basket of currencies, instead of only the USD, and allow the currency to float within strict bands.

In December 2015, CFETS unveiled the CFETSRMB Index to be used to assess exchange rate movements. This was an attempt to shift the market’s focus from the RMB against the USD exchange rate to the RMB’s performance against the basket of currencies used by its trading partners, reflecting the perspective that the exchange rate should capture the international trade flows of China. The original Index consisted of 13 currencies with weightings based mainly on a trade-weighted average, as such the USD had the largest weighting at 26.4%. In December 2016, 11 more currencies were added to the CFETS Index, resulting in a reduced weighting for the USD.

More recently, the CFETS announced that it would adjust weightings in its currency basket from January 1st, further reducing the USD weighting from 22.40% to 21.59%.

Year-on-year growth in the global trading of RMB has been the highest of any currency. Average daily volumes have increased from USD 119bn in 2013 to USD 285bn in 2019. Domestically, FX is the largest asset class, making FX swaps, at 48% of volume, the most widely traded product as market participants have become more sophisticated in trading FX instruments as tools to hedge risk and as a means of funding.

Despite the growth in the domestic FX market, it is still very small relative to GDP and its economic links with the rest of the world even when compared to other emerging market economies. It is expected that demand for more complex FX products will grow as banks look to offer more complex structured products to their clients and as investment managers seek alternative investment solutions in response to changes in regulation. The FX market should be encouraged to grow by enabling firms to structure yield-enhancing products and zero-cost hedging strategies using exotic options. The product offering could also extend to an exchange-traded market in FX futures and options that would provide end-users with alternative hedging tools as well as additional liquidity and transparency in the market.

Despite the growing domestic demand, the FX market—except for spot and FX swaps, which are highly liquid—is inefficient and costly, thus making it less attractive. A contributing factor is regulations restricting access to non-bank participants that trade both sides of the market. Hedging in the FX market is currently very directional, resulting in a build-up of risk by the banks, who act as liquidity providers. This incurs costs that need to be recovered through wider spreads, which dampens the demand from end-users. In order to further attract international capital and grow the domestic market through increased liquidity and transparency—as well as reducing the costs of trading—the restrictions over access to the market should be removed.

For participants transacting onshore, FX trades are governed by NAFMII master agreements. This practice restricts the ability of international market participants to trade with domestic commercial banks as they would normally use international master agreements to assist in the management of credit risk. The use of separate agreements between onshore and offshore trades creates basis risk because of the different treatment of collateral, settlement, and close-out netting. Consideration should be given to the introduction of international master agreements.

As China looks into removing its dependency on the USD, it will need to increase the use of the RMB as a settlement currency used to settle current account transactions. In 2018, the RMB was the eighth most active currency for domestic and international payments. In terms of international payments, the RMB ranked eighth in November 2018 with a share of 1.16%; in December 2020 neither its rank nor share had changed.

As noted, increased use of the RMB outside of China will result in increased familiarity among investors, which will result in much greater FII participation directly in China markets. China has set up USD 500 billion equivalent in CNY currency swap agreements with more than 30 countries. However, there need to be adequate offshore CNY deposits in order to ensure that there is adequate liquidity, and to do this China would need to run either a current or capital account deficit. Without a significant increase in RMB usage outside of China, projects such as the Belt and Road Initiative will continue to be funded in USD or local currency.

As we have noted above, there has been a great deal of financial market reform in China and we also recognize that, for reform to work, technical cooperation across multiple agencies is required, which can be challenging. However, from a practical standpoint, the implementation of these measures has not been as smooth as one would like. Some of these regulatory changes, although welcome, have given market practitioners insufficient time to respond. Providing ample notification of new rules as well as allowing enough time for public comment and implementation will significantly improve the regulatory rule-making process. More advance coordination would help to ensure sufficient industry buy-in and minimize implementation risks, which benefits everyone. Abandoning the practice of implementing regulations immediately after a consultation closes would go a long way to building trust in the process as clearly the responses could not have been given adequate consideration within such a short time period.

Conversely, other policy changes, once introduced, have been implemented more slowly than some market practitioners would like. It was a year before regulatory authorities approved the first majority stake in a domestic financial firm by an international bank, and licenses for some international rating agencies, underwriting licenses for fixed income participants, clearing licenses for bank and bank card payment firms take a significant amount of time—sometimes years—before being approved and seem to be quite often linked to the state of the political relationship with that firm’s country. Often, the update of tax legislation is even slower than other regulatory changes. For example, so far there are no tax regulations addressing the tax treatment of the new investments introduced by the new QFII regulation, which was released in September 2020. We believe that by opening foreign firm participation in the domestic market, China has an incredible opportunity to build on the experience of developed markets, avoid their past mistakes, and leapfrog their successes.

With 100% foreign ownership of Chinese private fund management companies (“PFMs”) being permitted since 2016, of Chinese banks since August 2018, and of Chinese securities companies, fund management companies (FMCs), and futures companies from April 2020, we have seen at least 32 wholly foreign-owned PFMs established (mostly in Shanghai, one in Shenzhen, two in Tianjin and two in Zhuhai) and at least six applications for a wholly foreign-owned FMC submitted to the CSRC for approval as of the end of 2020. We have neither seen any applications for wholly foreign-owned banks nor majority foreign-owned banks in China, but at least eight CSRC approved majority foreign-owned securities companies have been approved in China as of the end of 2020. The option for foreign interests to establish a wholly or majority foreign-owned entity in the Mainland is clearly present, but as we have observed, one cannot rely on the fact that one structure was approved and followed the same precedent. This is a high-risk strategy in China. Greater clarity by regulators as to the types of acceptable structures would provide much greater certainty to firms looking to set up or expand their business in China, which would make things more efficient for all sides.

Finally, China clearly wants to attract more foreign capital, as frequently noted, while FIIs clearly are interested in investing in China’s capital markets.