When China’s State Council announced in March its intention that Shanghai will be an international financial centre (IFC) by 2020, it barely merited media coverage at home. A shiver went down a few spines in New York and London, however. With Western markets and sensibilities still fragile, and recovery from financial crises and recession a long way off, China’s ambition to establish its own IFC was seen almost as a threat to the primacy of the US and Europe in global finance.
Some observers think the goal unrealistic, not least because they believe the government is still unwilling to let the currency float freely and open up the capital account. A rising currency and capital flight are not political risks worth taking while trying to support exporters and grow domestic consumption, they argue. And without these fundamental steps the IFC goal will remain a dream.
But a raft of recent developments suggests that Beijing means business – and indicate that 2020 is an implicit deadline for the liberalisation that the West has long clamoured for.
In September, China’s Ministry of Finance announced a plan to sell Rmb6bn ($879m) of bonds in the international markets to improve the “international status” of the renminbi and to help mainland companies raise funds in the offshore bond market.
Earlier steps in this drive to internationalise the currency have seen almost $100bn of renminbi swap lines established (with South Korea, Hong Kong, Malaysia, Belarus and Argentina) in six months. And since December 2008, the State Council has set up pilot schemes to enable five Chinese cities (Shanghai, Guangzhou, Shenzhen, Donguan and Zhuahai) to settle trade payments with Association of South-east Nations members in renminbi. Both developments are seen as steps towards full renminbi convertibility.
There are further indications that China is opening its markets. Last month, Beijing announced that it would start allowing foreign companies to list in China for the first time, albeit under a different listing regime.
Compared with developed financial centres, China’s capital markets are immature and opaque. Moreover, there have been plenty of previous plans that have come to nothing. Shanghai built a financial futures exchange nearly three years ago but trading has yet to begin. Other non-events include the launch of stock index futures trading and last year’s announcement that Beijing would introduce limited short selling and margin trading; both have failed to materialise.
That said, the growth is staggering. In terms of market capitalisation, the Shanghai Stock Exchange is already the third largest stock exchange in the world, behind New York and London. China’s debt markets are also expanding quickly. In 2008, corporate bond issuance almost doubled to nearly Rmb900bn, bringing total outstanding debt to Rmb1268bn, up 66% from the end of 2007.
China now boasts several of the world’s largest banks, all well capitalised and purged of non-performing loans. They cannot yet compete with foreign investment banks in terms of advisory, but in the bond markets, Chinese banks are beginning to take a bigger slice of the action right across Asia, helped along by the government’s $585bn stimulus plan.
But despite impressive growth and the increasing clout of the country’s banks, market discipline does not yet exist. The government continues to exercise huge influence on the allocation and pricing of financial resources through administrative intervention. This affects the assessment of risk, reduces pricing flexibility and limits the beneficial effects of market discipline.
Market norms are quickly set aside when the administration sees fit. At the height of the financial markets crisis, volatility in the equity markets prompted regulators to step in and shut down the primary equity markets for fear that investments would turn sour and investor anger would explode into social unrest.
China’s opaque and unpredictable legal and regulatory framework will also be a serious hurdle. “Without the establishment of the rule of law in China, including an independent judiciary and government transparency, an internationally competitive financial centre is not possible,” says Andy Rothman, China strategist at CLSA Asia-Pacific Markets.
Securities and company law is still way behind that of other financial centres. Things are improving, but slowly, says John Hartley, a partner at White & Case in Hong Kong. “The law lags behind the structures that people are trying to achieve. The government is unlikely to change the process, but it is clearly making real attempts to fill in the gaps.”
The gaps are still significant. Fear of capital flight and competition from foreign banks mean that new laws favour domestic firms, as foreign banks found out when loans to Ferrochina were wiped out after it went into administration last year. The 2007 insolvency law does little to protect offshore investors, and the offshore holding structure used to access Chinese companies has proved better at letting money into China than getting it out.
Obstacles to tackle
The main challenge to China’s ambitions may be more fundamental. While its leaders have so far managed to successfully weld capitalist-style models to a communist administration, they may not be able to continue doing so. Some argue that the holes in the model are already evident – and that this is a problem for Shanghai.
Yasheng Huang, professor of political economy and international management at the Sloan School of Management, Massachusetts Institute of Technology, questions the idea that China has been moving towards a free market economy.
Shanghai epitomises these trends, he says. Trumpeted as the most capitalist place on earth and therefore the natural home for international financial services in China, Mr Huang suggests that instead much of what is perceived as evidence of bottom-up entrepreneurialism is in fact Shanghai government-controlled capitalism.
Stephen Green, head of research for China at Standard Chartered in Shanghai, agrees that state-led growth will make the development of a vibrant service-based economy more problematic; and that is where the future growth of Shanghai (and China) will come from, he says.
“The service sector is state-owned, and that will make it difficult for the ‘flora and fauna’ that characterises every vibrant economic and financial centre to emerge. Unless Shanghai opens up the service sector to competition, it will not be able to encourage the development of the venture capitalist and private equity communities and the service providers that help to create a financial centre,” says Mr Green.
Growing an indigenous talent pool also takes time. And attracting talent from overseas is not as easy, not least because of China’s 45% tax rate – the highest personal income tax rate in the world. Yifan Hu, chief global economist with Citic Securities International in Hong Kong, says: “While GDP growth has averaged 9% to 10% for about 20 years and incomes have increased, the share of personal income as a percentage of GDP has decreased by about 1% per year in the same period. This means that wealth creation has benefited government and corporations more than individuals.”
Shanghai is already planning to introduce a tax subsidy by the end of the year – paid for by local government – for foreign nationals, which would reduce income tax to about 25%. It hopes this will help to make the city more attractive to foreign professionals.
What the local population will think of this is another matter.
Population: 1.3 billionPop. growth rate: 0.66%Area: 9.6 million sq kmReal GDP growth: 9%GDP per capita: $6000Current account: $426.1bnLargest sector (% of GDP): Industry (48.6%)Labour force: 807 millionUnemployment rate: 4%