Capital Account Convertibility and China’s Drive to Open its Financial Sector
China will push ahead with its efforts to open up the financial sector in the near term and allow greater convertibility of the currency under the capital account. Important areas where convertibility needs to be expanded include the primary share market as well as markets for derivatives and foreign exchange. These reform efforts will be made under a framework of stepped up macroprudential regulation and strengthened risk oversight.
China has been making steady gains in opening its financial sector，particularly in the current period of international asset reallocation. Recently，there have been significant adjustments in global liquidity amid Sino-US trade friction and US financial market volatility. In order to hedge against these factors，some global asset managers have been turning to markets which have a low correlation with those in the US and Europe. These markets need to meet a threshold of minimum requirements; they must have free capital flows，similar trading practices to developed markets and a more reliably regulated trading environment. China’s renminbi asset market is suitable in most aspects with one large exception - restrictions on access for foreign investors.
As China upgrades its economy it has also seen a restructuring of its balance of payments. It is estimated that the trade surplus will gradually decrease while international capital inflows will play a greater role in maintaining equilibrium in the payments balance. Against this background，a new trend is emerging in opening up the capital account. In July，for example，the Chinese government announced the Relevant Measures for Further Opening Up the Financial Sector. In September the foreign exchange regulator announced it would abolish investment quota restrictions for the Qualified Foreign Institutional Investors (QFII) and the Renminbi Qualified Foreign Institutional Investors (RQFII) programs. This article examines these measures and sheds light on what policies might be implemented in the future.
Past Progress
Internationally，there is no real standard for capital account convertibility. The International Monetary Fund (IMF) offers an assessment framework in its annual Report on Exchange Arrangements and Exchange Restrictions，however，and we’ll use that to give us an idea of how China compares with other countries at this time.
While there have been marked improvements in opening the capital account，some key areas still show limited openness，and these include cross-border asset allocation. According to the IMF’s Report on Exchange Arrangements and Exchange Restrictions (2018)，of the 40 items in the seven broad categories under China’s capital account，38 of them or 95% are convertible，partly convertible or basically convertible. Only two items are not convertible at all. On the surface，China appears to be close to the target of full capital account convertibility. But among the above-mentioned 38 items，only 10 of those with at least some degree of convertibility are related to direct investment. Investments in bonds are partially convertible and there is no convertibility for derivatives transactions and cross-border financing between residents and nonresidents.
From the perspective of global asset deployments，overseas capital allocations for Chinese assets are at low levels due to narrow investment channels，structural inefficiencies and an inability to conduct risk hedging. For instance，the utilization rate of the QFII and RQFII quotas has been relatively low. As of the end of August 2019，a total of 292 investors had been granted approvals for investments of a combined US$111.4 billion in Chinese stocks. But this represented only 37% of the total QFII quota of US$300 billion. As for RQFII，the total quota was 1.99 trillion yuan，and the utilization rate only 35%. On the other hand，although Chinese residents have seen the country’s economy expand rapidly with a significant rise in disposable income，more than 90% of the country’s residents have no funds invested offshore. The rate of Chinese overseas asset allocation is 4%-5% of total allocations，much lower than the average rate of over 15% in developed countries.
Despite the opening of some segments of China’s capital market，access to the primary market is limited. That has constrained financing channels for enterprises and inhibited growth of the real economy. China’s secondary market has been open to overseas capital since the introduction of the QFII program in 2002. The Shanghai-Hong Kong Stock Connect program was launched in 2014，linking the stock markets in the two cities. That was followed by the Shenzhen-Hong Kong Stock Connect project in 2016 and the Bond Connect plan in 2017. More recently，the Shanghai-London Stock Connect program was put in place，allowing access to both primary and secondary market offers (though initially the primary market access is for Chinese companies listing shares in London).
While there is no convertibility for primary share offers by foreign companies on the domestic market，removing the existing barriers should not be that difficult as there is convertibility in place for the secondary market by means of the stock connect program. Foreign investors can also issue bonds to mainland China investors through the Hong Kong market by using the Bond Connect mechanism. With some degree of access to the primary and secondary markets，a loosening of controls over the primary share market is not unthinkable. Removing the remaining obstacles to greater access would not only expand the financing channels for enterprises in mainland China，but would also provide more good quality investment options to domestic investors.
In terms of the foreign debt market，China has largely made good preparations for a gradual opening by improving the framework for macro-prudential regulation. It also has seen a steady climb in the use of offshore borrowings. The country’s cumulative balance of foreign debt reached US$1,965.2 billion as of the end of 2018.
China also has stepped up its efforts to open the foreign exchange market，but foreign institutions account for less than 1% of the transactions on the interbank foreign exchange market. Foreign participants in the Chinese market need financial derivative tools to hedge against risk，and the shortage of products is curtailing their activities. Additionally，allowing more foreign participation would also enhance China’ global pricing power. So greater access to the derivatives market should be part of the opening up process in the financial sector.
Advances have also been made in opening up the commodities markets. Overseas investors have been allowed to trade in renminbi-denominated crude oil futures，which have been listed on the Shanghai International Energy Exchange. Foreign investors have also been permitted to trade in iron ore futures on the Dalian Commodity Exchange.
Bringing in Overseas Capital
China’s opening up of the financial sector is largely aimed at bringing in overseas capital，assisting foreign investment by domestic enterprises and enhancing the interconnection between overseas and domestic markets.
The general consensus in the past had been that opening up the financial markets could result in unwanted volatility. But those concerns were overdone. In fact，opening up the financial sector is now needed more than ever to meet the financial requirements of the real economy. As participants in the world’s second largest economy，Chinese companies need to be competitive in the global marketplace. This is particularly true against the background of Sino-US trade friction. Overseas capital brought into China will not only participate in this country’s economic growth，but also help ensure sustainable，high-quality developmen