China’s Reforms: Will They Work?

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China’s Reforms: Will They Work? by Hayden Briscoe, AllianceBernstein

The internationalization of China’s currency is proceeding hand in hand with the liberalization of the country’s capital markets. If China can surmount its short-term challenges, the impact of these reforms on global economies and markets should be profound.

Of all China’s reforms, the one most likely to reverberate around the world is the liberalization of the country’s capital markets. In just a few years, it should lead to China’s bond and equity markets being incorporated into global indices, forcing a massive reweighting of portfolios as benchmark-observant investors reallocate assets to China just to stay market neutral.

To gauge the potential impact, it helps to review China’s progress on this reform to date.

China Has Opened the Door

The country began liberalizing its capital markets in 2002, when it launched the Qualified Foreign Institutional Investor (QFII) scheme, which allowed foreign investors to trade yuan renminbi (RMB)–denominated Class A Shares and government and corporate bonds on the Shanghai and Shenzen stock markets. Since then, the scheme has been steadily expanded. In 2011, the government established the Renminbi Qualified Foreign Institutional Investor (RQFII) program, to allow non-Chinese financial institutions to launch RMB-denominated funds for investment in mainland China. Like QFII, RQFII has grown steadily through a series of rule changes and quota increases (Display).

In late 2014, the process accelerated with the launch of Shanghai–Hong Kong Stock Connect, a system that enables share trading between the Hong Kong and Shanghai stock exchanges.

Participants are subject to quotas and fairly restrictive rules; as with QFII and RQFII, however, we expect these to be relaxed in time to enable participation to grow. The credibility of China’s progress in these areas has been recognized by the world’s central banks, many of which are now holding significant proportions of their foreign-exchange reserves—in some cases, up to 20%—in RMB.

Positive Move for Smaller Companies

Just as important as these cross-border developments are the steps China is taking to liberalize its domestic markets. This progress is part of the government’s policy to rebalance the economy from being driven primarily by export demand to a model in which domestic consumer demand plays a much bigger role than in the past. It’s also important from the point of view of making the domestic economy more competitive and attractive to foreign capital.

In 2014, for example, the People’s Bank of China (PBC) led a crackdown on the shadow banking sector and the government passed a new budget ruling curtailing the use of local government finance vehicles. The move will force provincial governments to borrow in the municipal bond market, which they will be able to do only after seeking permission from Beijing. This process should ensure, for example, that infrastructure spending becomes more targeted, with less spent on unproductive projects.

China’s latest step in liberalizing its domestic market came during the PBC’s surprise rate cut in November 2014, when banks were allowed to price their deposits at 1.2 times the benchmark rate compared to 1.1 times previously. This rate cut created a powerful incentive for smaller banks to attract deposits and offer cheap loans, and was a positive move for the small-to-medium-size enterprise sector, the dynamism of which will be crucial to China’s economic rebalancing.

China Will Meet Its Goals

These developments provide sufficient evidence that China is on track to achieve the internationalization of the RMB, the liberalization of domestic and international capital flows, and the rebalancing of its economy. The process is not without risk, and there is some uncertainty about how long it will take, but it has already acquired an impressive momentum.

All these elements help strengthen our conviction that China in due course will overcome its present difficulties and emerge as a major stabilizing force in the world economy and global financial markets.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.

Hayden Briscoe is Director of Asia-Pacific Fixed Income at AllianceBernstein.

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