Even after the British seized control of five key Chinese ports, first by force and then by treaty, the Chinese resisted foreign efforts to further open their domestic markets to two-way trading arrangements. That eventually lead to the Boxer Rebellion in which reticent Chinese rose against what they saw as the yoke of foreign mercantilism.
The point here is that the Chinese have always wanted to deal with Western interests on their terms and their schedule. They’ve also been quite successful in turning the Western mercantilism trading model of the 1700s and 1800s against us, pushing their goods into our markets while purchasing very little from us and amassing huge foreign currency reserves in the process.
But just as Western powers had to largely abandon their mercantilist ways to advance their own economic and political development, the Chinese have reached the point in their development cycle where they will have to do the same if they wish to grow that wealth.
Typical of their incrementalist approach, we’ve seen the Chinese tentatively move in that direction.
For instance, while China remains a target of criticism because of the tight control it maintains on the renminbi, it has taken a number of steps over the past decade to liberalize and internationalize the currency. Over the past decade it has increased the convertibility of the renminbi and allowed the formation of an offshore renminbi market in Hong Kong.
Long a financial proving ground thanks to its special status as a special administrative region of China, highly westernized Hong Kong has long been the mainland’s primary financial connection with the outside world. It has also proven a useful chokepoint for capital flows into and out of China, allowing the central government to retain tighter control of its financial experiments.
Again, that’s why Hong Kong was chosen as the base of operations for companies to issue renminbi-denominated debt, also known as Dim Sum bonds, to foreign investors when the program began in 2007.
As a result, China has developed a dual currency market, one for onshore renminbi and one for offshore renminbi, with the goal of denying foreigners direct access to Chinese capital markets while allowing the Chinese to tap foreign capital.
The central government has also allowed foreign investors to trade special H-shares, a class of equities issued by Chinese companies specifically for foreigners, on the Hong Kong Stock Exchange while denying them access to A-shares which trade only in China.
The only way for foreigners to gain access to A-shares is to be designated a Qualified Foreign Institutional Investor (QFII), a designation that Beijing is particularly stingy with. Since the QFII program was begun in 2002 through last year, only 135 foreign investment firms had been granted the designation. On top of that, firms that had managed to become QFIIs where subject to investment ceilings of just USD30 billion.
But as economic growth has slowed and foreigners have become more hesitant to invest in China at all, the central government has finally begun to see the wisdom of liberalizing foreign investment. And while true to the Chinese form the liberalizations have been extremely incremental, they mark another step down a path of internationalization that the government will find difficult, if not impossible, to reverse down the road.
So far in 2012 alone, 57 new foreign investors have been designated as QFIIs, bringing the total to 192. The China Securities Regulatory Commission (CSRC) has also markedly increased the investment ceiling from USD30 billion to USD80 billion for approved investors, more than doubling the amount of allowed potential foreign investment almost overnight.
The CSRC has also established a policy allowing 70 billion yuan raised by offshore exchange traded funds to be invested in the mainland capital market. While that’s only about USD11 billion, it’s a marked loosening of extremely stringent capital controls. It has also begun allowing QFIIs to enter the domestic interbank bond market.
The greatest fear of the Chinese government is that by allowing foreign investors direct access to mainland capital markets, it’s opening the door to flows of hot money that can leave just as quickly as it entered.
The point of allowing foreign investment is to drive wealth creation for its own citizens, an important function of the Chinese equity market. However, if equities are allowed to become extremely volatile because of foreign money flowing in one day and out the next, it strikes at the credibility of the central government.
Consequently, only long-term investors such as asset management companies, insurance outfits and pension funds are made QFIIs. It will probably take several more years before individual investors will be able to log into their own Interactive Brokers accounts and trade directly in Shanghai.
Still, these are important steps down the path of market liberalization and their timing is significant. Coming as the Chinese leadership is turning over, they’re signals that the new leaders will continue ever so slowly loosening their grip on the country’s capital markets.
China’s market reforms will come in fits and starts, particularly if the Party ever perceives its hold on political power as threatened. However, the country has reached a point where it has little choice but to open its markets if it wishes to maintain a leading role in the global economy. That will ultimately benefit all investors.
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