This article was produced in collaboration with the Knowledge@Wharton.
Earlier this year, Chinese President Xi Jinping pledged that the country will accelerate the opening up of its financial sector in a series of “landmark” measures to be launched in 2018. They include fast-tracking foreign access to the Chinese insurance industry, easing restrictions for entry and expansion of foreign financial institutions, and improving the investment climate. China, he said, “will enter a new phase of opening up.”
The reality is likely to be a bit more complicated. While China has come a long way in the last four decades — liberalizing trade, property rights, foreign direct investments and other key areas of the economy — one sector where it has been more cautious to open is the financial sector.
A decade ago, foreign banks were allowed to incorporate in China and many had hoped to establish a strong foothold in a nation whose savings rate is 46% of GDP. Not only didn’t it happen, they’ve lost ground. Their market share fell from 2.38% in 2007, according to KPMG, to a dismal 1.3% in 2017. That’s a pittance of China’s total bank assets of 244 trillion RMB ($37 trillion).
There were a number of challenges: limits on foreign ownership of domestic institutions that hampered expansion; competition from China’s five largest state-owned banks with their political clout and vast network of branches; capital controls that made it tougher to move money across borders; and under-developed financial markets, among other issues. Pile on top of it growing competition from non-bank firms such as Ant Financial, a spinoff from Alibaba. Ant has 870 million customers and handles more than $2.4 trillion in mobile payments every three months, according to Bloomberg.
In November 2017, after a visit from President Trump, China announced that it was further opening up its financial sector by easing restrictions on foreign businesses. One of the biggest changes: Foreign firms can now own up to 51% of domestic securities, insurance and fund management firms — and the cap disappears after three years.
Shortly after, UBS became the first global bank to raise its hand and apply for a 51% ownership in its Chinese securities joint venture, up from 25%. Nomura Holdings and JPMorgan Chase have followed suit, even though the latter left its Chinese joint venture just two years earlier.
Will this time be different? “Many believe that the financial sector will be the next area for substantial reforms, but it is still far from clear how such reforms will be implemented,” said Wharton management professor Minyuan Zhao. “The opportunities are there, since China is still growing at a relatively fast rate. However, policy uncertainty, as well as the high leverage in the Chinese economy, will pose challenges for foreign financial institutions. In addition, for those financial institutions that used to follow their clients, mostly multinational firms, the slowing down of foreign direct investment into China has also narrowed that space.”
Marshall Meyer, Wharton professor emeritus of management, also remained cautious. He remembered the prior experience of foreign banks entering joint ventures with Chinese financial institutions and “none of these investments worked. They almost all pulled out.” Although China will now allow foreign financial institutions to hold majority ownership, Meyer is not certain they can always exercise control. He cites the Company Law of the People’s Republic of China, which states that the controlling shareholder can be an entity that doesn’t have a majority stake. “It’s control, not ownership, that makes the difference.”
China had become more wary about further opening up its financial sector, especially after the financial crisis of 2008 showed that interlinking markets can cause domino-like turbulence worldwide. While China largely escaped the conflagration, its global business did slow.
So the government pumped RMB 4 trillion ($630 billion) to keep its economy growing. “Without the Chinese government intervention, probably China’s economy would have begun slowing a couple of years before the Great Recession,” Meyer said. The stimulus “put the government on a totally different footing. They became a promoter of growth.”
What about the Debt?
Problems faced by China’s financial system also need to be addressed before foreign financial institutions can fully seize its opportunities. “China’s banking reform is a long-term process due to the size of the system and the amount of distortion that needs to be purged,” said Chi Lo, senior economist at BNP Paribas Asset Management in Hong Kong. “Beijing started the reform last year by forcing shadow banks and non-bank financial institutions to deleverage because these are the major financial stress points in the system due to the significant amount of rent-seeking and regulatory arbitrage activities by these institutions.”
China’s massive debt — ranging from banks’ non-performing loans extended to state-owned enterprises to those in shadow banking and household mortgages — is a concern to top officials, who want to preserve financial stability. Lo said that while China has targeted its deleveraging measures toward the wholesale funding market and non-bank financial institutions, the impact was felt throughout the system with total credit growth declining and the corporate bond yield spread rising last year. “Controlling systemic risk remains a high priority in 2018,” he said.
But Lo doesn’t think the debt burden will turn into a crisis, similar to what Greece experienced. The key reasons for that, he noted, are that China’s debt is mostly domestically financed and denominated in local currency — it has relatively little external debt. Meanwhile, China remains a net global creditor and enjoys the largest trade surplus in the world. And having its capital account remain relatively closed helps restrict foreign borrowing. As such, Lo added, China’s debt is likely to be much more stable than that of other debt-ridden countries.
China is also unlikely to see banking troubles as a result of its debt. In Western economies, when trouble looms, lenders would tighten credit. “Bank runs would start and the banking system would collapse,” Lo said. But the creditors in China are the “households, who are ultimately backed by the government’s implicit guarantee policy. Even if the Chinese banking system is not robust, there is no loss of public confidence so that the probability of bank runs in China is very low.” China’s closed capital account also helps “lock up domestic liquidity, providing a backstop for keeping the banking system whole,” he added.
Franklin Allen, Wharton professor emeritus of finance, is not overly concerned about China’s debt as well. He pointed out that the Chinese central government “has considerable power” over debt-laden banks and firms. “They own the majority of shares, they appoint the executives and they regulate them,” he said. “The central government also has fairly low debt.”
China’s so-called “socialist market economy” has always been driven by the goals of the state, which are economic growth in a modern economy with stability and prosperity for all. Over the last 40 years, the country has embarked on a dual economic track: weaning its dependence from state-owned enterprises to more reliance on the private sector in such a way as to maintain social order. Workers displaced by the change were given social safety nets. Deng Xiaoping, China’s former paramount leader, likened the transition to “crossing the river by feeling for stones.”
The actions of China must always be seen through the prism of the goals of the state, rather than simply the desire for growth. Indeed, its two stock exchanges — in Shanghai and Shenzhen — were developed to give state-owned firms another vehicle to raise capital. The same motivation gave rise to its bond market, which is now the third largest in the world after the U.S. and Japan. Because the state’s goals take precedence, many securities listed in these markets are state-owned enterprises. Delistings are rare; that means firms the market would have booted out long ago remain on the exchanges, distorting their true value.
According to a 2018 research paper by Wharton’s Allen, the Shanghai and Shenzhen exchanges have underperformed relative to China’s strong economic performance. Usually, countries with robust growth see a similar uptick in their stock market. Why the disconnect in China? The paper, “Dissecting the Long-term Performance of the Chinese Stock Market,” cited the problematic listing and delisting process that favors state-owned entities with political connections, as well as deficiencies in corporate governance, as reasons why the domestic stock market and China’s economy do not move together more closely.
Indeed, China’s “top-down approach to market building” stands in contrast to the private sector’s way, where companies use assets and resources within their control guided by institutional market knowledge, said Ann Rutledge, adjunct associate professor at the Hong Kong University of Science and Technology.
The key for foreign firms is to understand the raison d’etre of China’s securitization market, Rutledge said. It’s not about creating a market for its own sake but hitting another milestone towards modernization in service of its national goals. “Money is good but the needs of the people and the state come first.”
Not to be overlooked is China’s desire to control its currency and one reason for its inward focus, Rutledge said. But its quest to internationalize the renminbi — where the currency is widely held by investors outside of China for use in payments, settlements, investments and reserves — has slowed down sharply since 2014 due to changes in economic conditions, BNP’s Lo said. It was once a high policy priority in facilitating China’s financial liberalization.
In a sense, China also views the role of renminbi internationalization — as a force to push through financial deregulation — to be largely completed, Lo said. “Hence, its official importance has diminished,” he added. Specifically, the admission of the renminbi into the Special Drawing Rights currency basket of the International Monetary Fund signaled international recognition of China’s achievement in financial liberalization, he said.
Another reason renminbi internationalization is not moving faster: It has turned from a political boon to a bane. “The success of the offshore market in making the renminbi more widely used has also allowed offshore players to sell short the Chinese currency,” Lo said. It created “unwelcome volatility” just when the pressure of structural rebalancing of China’s domestic economy was also intensifying, he said. But that doesn’t mean these efforts have failed, Lo said. They are just being slowed down.
Eventually, China wants to have a fully convertible currency. But it’s unclear when this will occur because the process of opening up the capital account, which goes hand in hand with renminbi convertibility, is “uncertain and slow,” Lo said. “A fully convertible renminbi would mean letting go of all controls by the Chinese government, which I doubt will happen because the tenet of the Communist Party is control.” That means the renminbi could stay as a managed float for some time. “There is a lot that Beijing has to fix before the system is ready for free capital flows,” Lo added.
Wharton’s Zhao sees the same outcome. “China’s renminbi internationalization efforts have met some strong headwinds. The pool of overseas renminbi is too small for price discovery, and the strong-handed interventions from the state have spooked many investors,” she said. “Will the renminbi be fully convertible one day? Maybe, but certainly not in the near future.”
With plenty of reforms still needed, what opportunities are there for foreign banks angling for a bigger share of China’s wealth? Wharton’s Meyer said for now they could focus on managing the overseas assets of rich Chinese. Wealth is highly concentrated in China and the choices for Chinese families to invest are limited domestically. “The trick is to compete for the overseas assets, not the domestic assets” where Chinese banks have the advantage, he said. “There’s a lot of money that wants to leave China. There’s more than enough to keep the [foreign] banks happy.”