Buyer Beware: China’s Uneven Financial Market Reform Presents Risks for Foreign Investors
December 18, 2020
By Yian Ke
Amid the global recession and ultra-low interest rates in advanced economies, investors have increasingly turned to China – the only major economy projected to grow in 2020 – for returns. To encourage foreign investment, Chinese authorities have accelerated their opening of mainland capital markets. These trends have spurred a record amount of foreign portfolio investment into China, with foreign holdings of domestic RMB assets reaching $1.16 trillion in September 2020, up from $919 billion in December 2019 and $669 billion in December 2018.
However, China’s 2015-2016 currency depreciation and capital exodus still loom large for foreign investors. During that crisis, the scale of the People’s Bank of China’s (PBOC) intervention to defend the yuan underscored the central bank’s determination to control the value of the exchange rate and prioritize financial stability, even at the cost of opening and reform. As China’s capital account liberalization stalled, investors questioned Beijing’s commitment to moving toward a more market-determined exchange rate and limit capital controls. Now, as investors flock to China for returns, mainland financial markets are still evolving and maturing. While there are opportunities for higher returns, foreign investors must be prepared for an uneven process of financial reform.
The 2015-2016 crisis began in August when the PBOC initiated a small-scale devaluation of the yuan, which caused widespread panic among investors who rushed to take capital out of China. The sudden PBOC action came on the heels of a June stock market crash that sapped investors’ confidence on the stability of China’s financial system. Due to the PBOC’s poor communication and execution, investors perceived the devaluation as a means to boost Chinese exports to compensate for weak underlying economic performance. Although the central bank quickly stepped in to shore up the yuan’s value and limit speculative offshore traders, capital outflows accelerated. After an estimated $850 billion of China’s foreign-exchange reserves disappeared via cross-border arbitrage, the PBOC tightened its controls on capital outflows to a degree not seen since the Asian financial crisis.
Prior to the crisis, Beijing had taken progressive steps towards capital account liberalization, including easing domestic interest rate controls that would prevent banks and households from taking funds overseas under an open capital account. The PBOC reduced foreign exchange intervention and encouraged the internationalization of the RMB from 2010-2015, and again moved closer to a flexible market-determined exchange rate after the 2015-2016 episode. The Shanghai/Shenzhen-Hong Kong Stock Connect programs were launched in 2014 and 2016, respectively, to allow Hong Kong and Mainland investors to trade on the each other’s market. However, the practical effects of these policy reforms were limited, and opening stalled after 2015.
That crisis exposed the fragility of the Chinese financial system despite nascent reforms. China’s economic growth in the past decade has been fueled by the rapid expansion of credit, which has resulted in a rising level of indebtedness and credit risks in China’s financial system. Between 2009 and 2015, credit growth averaged 20 percent per year, much higher than nominal GDP growth, with the nonfinancial corporate credit-to-GDP-ratio reaching above 200 percent by the end of 2015. In response, since 2016, Beijing has rolled out an aggressive deleveraging campaign that tightened regulations to slow credit growth and clamp down on shadow banking. The deleveraging campaign reduced aggregate risks within the financial system by tightening lending conditions, but in the process, also put firms at greater risk to default on their debts. In a 2017 article, leading Chinese economist Yongding Yu warned that China’s financial system was still not strong enough to withstand external shocks and advised patience on further opening of the capital account.
After a near four-year hibernation period, China’s financial opening resumed in 2020 as the country managed a relatively quick recovery from the pandemic. As of April 1, Beijing authorized foreign financial institutions to take majority ownership stakes in their joint venture securities firms in China. The China Securities Regulatory Commission (CSRC) officially combined two major inbound investment schemes to expand access for foreign institutional investment, effective November 1. Under the new rules, foreign firms are also able to repatriate a larger amount of funds in the currency of their original investment, which was previously under strict regulation.
The relatively stronger outlook for the Chinese economy amid a global recession have made the Chinese bond market an attractive destination for global investors. China’s investment-grade sovereign bonds offer more than three percent yields in a world of zero to negative returns in developed market peers. The yuan, at 6.53 as of December 13, has rallied to its strongest position since July 2018. Foreign investors will also have increased exposure to China’s $15 trillion securities market as major indexes increase their weighting of Chinese assets, with Morgan Stanley analysts estimating future inflows of $60 billion to $90 billion.
However, as foreign investors have piled into the Chinese market, there have been a series of high-profile corporate bond defaults that could be an ominous sign for broader stability. Recent defaults by Chinese state-linked firms, including Yongcheng Coal & Electricity Holding Group, Tsinghua Unigroup, and Brilliance Auto Group Holdings, have shaken financial markets and pressured banks to shed riskier assets. Beijing has gradually pulled back implicit state guarantees on assets as it progressed the goal of market-oriented financial reform. The market is finding its way to price the risk of deteriorating policy credibility, a new type of financial risk that did not exist in China before. If investors no longer trust that Beijing will support distressed assets, the Chinese financial system could enter an especially volatile period just as foreign investors gain increased access and exposure.
Having learned from the 2015-2016 crisis, Chinese regulators today are sending clear signals to the market that corporates must manage risks of defaults on their own. The country’s top economic planner also tightened supervision over corporate bond issuance and increased default investigations. It will be a long and painful but necessary process for Chinese local governments, banks, state-linked firms, and holders of Chinese bonds if the market is to begin to price credit according to risks. In the short-term, investors will have to stomach an uneven process of managing bankruptcies. Nonetheless, Beijing’s increased tolerance for corporate defaults should serve to better allocate credit, bolster long-term financial stability and ease integration into global markets.
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