China's markets open up

Taking the long view on China has been a consistent mantra for investors for decades, and it has proved to be the right strategy as the country has gradually opened up its markets.

Investors had reason to do so after Chinese authorities recently tightened rules on big technology and data companies, and the education sector. In addition, China’s State Council said it would strengthen the protection of sensitive data related to overseas listings, which had an immediate effect on the shares of some U.S.-listed Chinese tech companies.

Coming amid the ongoing Covid-19 pandemic and uncertainty over the pace of economic recovery, these regulatory headwinds triggered concerns in financial markets about China's long-term policy direction.

But while there is much discussion of so-called “decoupling” of the U.S. and Chinese financial markets—whereby links between the two start to unravel in favor of reliance on domestic listings venues and sources of capital—this does not imply any change to the overall trajectory of China’s market opening. Only last November, China set another milestone by allowing greater access to foreign investors to its increasingly sophisticated futures markets.

“Over the long-term China definitely wants its markets to be more open than now. Globally, investors are still very much underweight in China compared to the size of the economy, and stock and bond markets,” says Tao Wang, Head of Asia Economics and Chief China Economist at UBS.

“That doesn’t mean China won’t implement regulations they think may achieve other objectives, and having those regulations doesn’t necessarily mean that they are turning against investors or further market opening.”

In the last two decades, foreign investors have been permitted access to China’s onshore equity markets via the qualified foreign institutional investor (QFII) scheme, which allows entities with QFII designation to invest in Chinese equities and bonds without having to incorporate locally.

Over the years, criteria such as eligibility and investment options have been gradually liberalized. For example, in 2014, overseas investors were effectively allowed to trade in mainland Chinese stocks on Hong Kong Exchanges and Clearing (HKEx) with the introduction of Stock Connect.

Between 2017 and 2020, foreign holdings of Chinese equities grew four-and-a-half times to about 8–9 percent of the free-float market capitalization of the A-share equity market, according to UBS. That year saw the launch of Bond Connect, connecting China’s onshore and offshore bond markets. This became the main channel for international investors to invest in China’s Interbank Bond Market.

At the same time, the inclusion of Chinese equities and bonds in global benchmark indices has continued apace. FTSE Russell said in March 2021 that Chinese government bonds would be included in the FTSE World Government Bond Index (WGBI), beginning at the end of October. “Ongoing reforms to the Chinese government bond market warrant inclusion,” the index provider said.

Reforms that helped qualify China for the WGBI include allowing internationally accepted practices such as “rolling settlement,” whereby deals can be settled later if the parties to the transaction agree, and allowing users of Bond Connect to use up to three settlement banks in Hong Kong to help with foreign currency hedging in relation to their bond investments.

In addition, financial market regulators in China have been responsive to foreign investor concerns.

Regulators have told foreign funds and banks that tighter regulations were needed to maintain sustainability, stability and security. UBS analysts interpret this to mean that Chinese authorities wish to contain leverage and financial risk; reduce social inequality and improve social harmony; reduce monopoly power and enhance government oversight of market rules; and improve data and information security.

Furthermore, Chinese companies wanting to list on U.S. exchanges are now being required to disclose more information, according to recent rulings by the Securities and Exchange Commission, the U.S. market watchdog. The China Securities Regulatory Commission (CSRC) responded by noting that “strengthening regulatory co-operation is the inevitable path” as growing numbers of companies, investors and financial services providers participate in each country’s markets.

The Chinese regulator’s measured response leads UBS analysts to believe that China will continue to open domestic financial markets, as financial integration can help guard against decoupling pressures.

Private capital, including private equity and hedge funds, has been a strong component of foreign inflows, says David Chin, Head of Investment Bank, APAC and China Country Head, UBS. He doesn’t expect this to change.

Not only are foreign investors being granted wider access to China’s bond and equity markets, but foreign asset managers are also being allowed to manage an increasing share of China’s vast savings pool. Recent reforms have allowed foreign firms to take majority ownership of Chinese asset management and securities businesses. UBS in 2018 became the first foreign bank to increase its stake in a securities joint venture to 51 percent.

At the same time, the opening of China’s markets is going in both directions. With Chinese investors still underweight in global assets, foreign asset managers are keen to tap into the vast domestic savings pool in China. “It’s a two-way opening up,” says Tommie Fang, Head of China Equity, UBS. “With global investors coming in, the next phase is for domestic investors to be able to invest more broadly.”

As with most trends in China, this will be a step-by-step process. “One has to bear in mind that 30 years ago, the capital markets did not exist in China so everything is happening at a very fast pace and that’s why, once in a while, there will be moments of pause,” says Mr. Chin. “But I’m confident that things are moving in the right direction.”

Views correct as at 3 September 2021.