The internationalisation of China’s capital markets could well be the biggest single influence on global financial markets in a generation. Since the launch of the ground- breaking Connect platforms in 2014, linking the Mainland financial markets with Hong Kong’s markets, there has been a significant acceleration in the opening up of China’s capital markets. Set against today’s more complex geopolitical backdrop, the next phase of integration between the Mainland and international markets will undoubtedly require further evolution in both market infrastructure and the global financial regulatory framework.
Connecting the World to China
To date, Stock Connect has seen more than US$1.7 trillion of total turnover. As at the end of 2018, this channel represented 58% of the US$172 billion foreign portfolio holdings in Chinese onshore equities. Bond Connect, launched in 2017, has seen total turnover to date of US$210 billion, and accounts for 10% of foreign holdings in China’s onshore bond market.
The relative ease of access offered by the Connect platforms, coupled with the con- fidence provided by Hong Kong-based custody, has allowed Mainland Chinese securities to be included in a number of international benchmark indices for the first time.
Following initial inclusion of China A-shares in the MSCI Emerging Markets Index last year, MSCI announced in March that the weighting of China A-shares in the index would increase by more than four times by November this year. Similarly, FTSE Russell will begin transitioning Chinese A-shares to secondary emerging market status within its FTSE Global Equity Index Series starting from June this year. Separately, Bloomberg began including Chinese bonds in the Bloomberg Barclays Global Aggregate Index from last month. These inclusions are major milestones and are expected to drive inflows of over US$200 billion into the Mainland capital markets in the next year. Over time, as China’s foreign ownership increases to international levels, foreign portfolio investment in Mainland securities is estimated to rise to US$3 trillion.
Given the significant differences between Chinese and international market structures, continual enhancements are being made to the Connect platforms to improve user experience. For example, to ease the operational strain arising from China’s T+0 settlement cycle, particularly for fund managers on the US West Coast, Hong Kong Exchanges and Clearing (HKEX) is working on a blockchain-based solution for trade allocations that makes use of smart contracts for settlement instructions. Other anticipated enhancements to Connect include adding more eligible securities in both markets and enabling cross-border trading even where one market is closed for holidays.
As international holdings in Mainland Chinese securities grow, there has been increasing demand for better risk management tools, including the ability to short-sell and access onshore and offshore derivatives in equities, interest rates and FX. To raise the capital efficiency of their Chinese securities hol- dings, international investors are now increasingly demanding the ability to pledge, collateralise and repo these assets to generate liquidity.
Two months ago, HKEX and MSCI announced the launch, subject to regulatory approval, of a futures contract on the MSCI China A Index. This is a very positive start, but much more is needed. The solutions will depend not only on infrastructure providers, but also on Chinese and international regulators and policymakers.
To give Chinese regulators sufficient comfort to endorse a broader portfolio of risk and liquidity management tools, transparency levels for foreign investors must be brought in line with the Chinese domestic system. This would allow the regulator to track each investor’s securities transactions and holdings in real-time. This reflects global regulatory trends, ranging from know-your-customer rules to European legal entity identifiers, and the post-financial crisis drive towards central clearing of OTC derivatives. The implementation challenge of this will fall to market infrastructure providers like HKEX, and to market participants. New technology will play a critical role and brings hope of significant collateral benefits in the form of greater efficiencies.
To bring greater capital efficiency to Chinese securities holdings, however, policymakers will also need to address the international financial and regulatory framework. It is necessary to create a more level playing field for Chinese securities, particularly in areas such as risk weightings of sovereign securities under the Bank for International Settlements’ Basel rules for the banking sector.
Connecting China to the World
While international market participants un- derstandably focus on the Connect platforms as a way to access and invest in Chinese securities, at HKEX we are much more excited about the Chinese outbound invest- ment story. With US$24 trillion of China’s savings sitting in bank deposits, this repre- sents the largest untapped pool of capital in the world, the deployment of which has the potential to transform global capital markets.
Given its growing middle class and aging demographics, the need for China’s population to generate better returns to support post-retirement lifestyles is undeniable. At the same time, as the private sector overtakes state owned enterprises as the primary driver of economic growth, it will no longer be tenable for the Chinese state to underwrite credit risk in the economy through implicit guarantees to depositors. This has forced policymakers to support a shift towards capital markets for funding.
As China’s savings are redeployed into capital markets, the demand for investment diversification will inevitably lead to some portion of these assets being allocated internationally. However, for China this poses some significant challenges.
First, there is no doubt that China’s closed capital account gives the Chinese Government significant diplomatic policy levers, through the ability to control access to its market and the ability to control the flow of its citizens’ capital. Such powerful policy tools will be hard to give up. Second, today, when Chinese investors invest in international securities markets beyond Hong Kong, ultimate custody generally falls either to a US global custodian or an international CSD. Given more widespread use of financial sanctions in international policy in recent years, and having observed the vulnerability of these institutions to Western pressure, there is understandably some reluctance among Chinese policymakers to expose China to such financial security risks. Third, unlike the US, China does not have the clout to impose laws like the Foreign Account Tax Compliance Act (FATCA) on the rest of the world, meaning that allowing free flows of capital would be accompanied by significantly greater risks of tax avoidance.
Therefore, the Connect concept, which offers a high degree of transparency within a «closed loop» system for securities trading and settlement, is ideally suited to meet China’s near- and medium-term needs as it pursues greater outbound capital markets internationalisation. The benefits for capital users around the world will be significant. That said, as we have seen from the impact that Chinese outbound investment flows have had on property markets from Vancouver to Sydney, this is a process that must be managed carefully.
As Asia’s leading financial centre, Hong Kong is the trusted venue of choice for both China and international investors. Hong Kong has a common law legal system based on the rule of law, as well as international practices and regulatory standards trusted and respected around the world. In the coming years, Hong Kong will continue to innovate and upgrade its infrastructure to support both the inbound and outbound internationalisation of China’s capital markets. I would urge international market participants, policymakers and regulators to ensure that they are adequately prepared to meet the opportunities and challenges that this presents.
* First appeared in the International Securities Services Association Newsletter (May 2019)
