“Old ways won’t open new doors”, goes an old saying.
Faced with physical travel restrictions due to Covid-19 and the higher barriers in the global marketplace amid rising anti-China sentiment from the US, China pivoted to step up the pace of opening its voluminous capital markets to the world.
The strategic intent to crack open the gates to its capital markets to international investors was set in motion almost 20 years ago, but this renewed sense of urgency is sparked by a confluence of factors including escalating US-China tensions, the economic shock caused by the Covid-19 pandemic and rapid economic transformation in China. We see this jumpstart in China’s pace of capital market reform and CNY internationalisation as a significant signpost that warrants attention of global investors.
High-profile global mutual fund companies recently received approval to set up China units to tap the estimated CNY 17.7 trillion (USD 2.6 trillion) domestic mutual fund market. Top-tier foreign securities houses have also increased their stakes in Chinese joint-venture firms after China lifted the cap on foreign shareholdings in securities and fund management firms in April 2020.
Starting in 2002, foreign investor access to Chinese capital markets was a privilege accorded to institutional investors (subject to strict quotas) via the Qualified Foreign Institutional Investor (QFII) scheme, followed by the Renminbi Qualified Foreign Institutional Investor (RQFII) scheme introduced in 2011.
In May this year, these quotas were scrapped. Last month, Chinese regulators – the China Securities Regulatory Commission (CSRC), People’s Bank of China (PBOC), and State Administration of Foreign Exchange (SAFE) – announced that both schemes will be merged in November, along with a slew of measures to improve access by simplifying processes, clarify regulatory implementation and increase scope to include more asset types, including private investment funds, asset-backed securities, financial futures, commodity futures, options, bond repo transactions, margin trading and securities financing on stock exchanges, and securities lending.
Connecting Stocks, Bonds, and now Wealth
The Shanghai-Hong Kong Stock Connect (沪港通) was introduced in November 2014 to bridge cross-border equity trading between the Hong Kong and Shanghai Stock Exchanges. This novel mutual market access effectively allowed Hong Kong and international investors to invest Northbound in A shares – previously the domain of institutional investors. Southbound trading on the Hong Kong bourse also opened doors for Mainland Chinese investors in invest in Hong Kong stocks.
This scheme (later renamed Stock Connect) was expanded to include the Shenzhen Stock Exchange (深港通) in December 2016. Today, over 2,000 Shanghai-, Shenzhen- and HK-listed shares that meet stringent eligibility criteria are traded via the scheme, subject to a tightly monitored daily quota with a “net buy” value of CNY52 billion and CNY42 billion for Northbound/Southbound transactions for each of the Shanghai/Shenzhen Connect channels.
The carefully calibrated increase in equity market access is in lock-step with increased inclusion factor of A shares to 20% at end of 2019 (from 5%) into MSCI benchmark Indices for China and emerging markets. In a scenario of full inclusion into the MSCI Emerging Markets Index, China would make up over 40% of the index (based on April 2019 proforma calculations). Foreign ownership of China A shares or the world’s second largest market remains modest at approximately 4% of market capitalisation, indicating significant potential upside upon inflows from international investors.
Bond Connect ( 债券通 ) celebrated its 3rd anniversary in July 2020, having onboarded over 2000 investors and generated cumulative turnover in excess of CNY 6 trillion. The extension of mutual market access to bonds was the harbinger for the inclusion of Chinese bonds into the Bloomberg Barclays Global Aggregate Index and the JPMorgan Government Bond Index Emerging Markets indices, another major step towards capital market internationalisation.
Chinese government bonds (CGBs) will be added into the benchmark FTSE World Government Bond Index (WGBI) starting October 2021 (subject to final confirmation in March 2021). Estimated buying by global bond fund managers who track the index is around USD120 billion of CGBs, as they phase in their allocation to Chinese bonds in line with index inclusion.
Beyond linkages in stocks and bonds, Wealth Management Connect (a cross-boundary wealth management connect pilot scheme) for the Guangdong-Hong Kong-Macao Greater Bay Area (GBA) was jointly announced by the Hong Kong Monetary Authority (HKMA), the People’s Bank of China (PBoC), and the Monetary Authority of Macao (AMCM) in June. Individual residents of GBA cities can invest Southbound in eligible wealth management products distributed by HK and Macao banks, while a reciprocal Northbound channel allows HK and Macao residents with designated investment accounts to invest in wealth management products from China banks.
ADR returnees and listing reforms
The hawkishness of the Trump administration towards China companies has hastened the pace for Chinese companies with American Depositary Receipt (ADR) listings to seek secondary listings on the Hong Kong and China bourses. The US President’s Working Group on Financial Markets called for new companies seeking a US listing to comply with US audit standards and greater audit scrutiny for currently listed companies. For currently US-listed companies, a transition period until January 1, 2022 is given to comply with new standards, failing which delisting may be imminent.
Home-bound listings of at least 20 China ADRs can be expected over the coming year. Selected listing candidates target Hong Kong Exchange listings and eligibility for Southbound flows via Stock Connect, while others aim for dual listing on the Hong Kong and Chinese exchanges. With increasingly onerous criteria for US listings, China companies with listing ambitions will see China, Hong Kong and Singapore exchanges as viable destinations, especially as the investment community and eco-system in Asia matures and expands to include vibrant futures, derivatives and private markets.
Domestically, China has also enhanced the attractiveness of its Nasdaq-style exchanges for innovative growth companies and start-ups with the launch of registration-based IPOs on ChiNext this year, after implementation of the disclosurebased listing regime (vs. the traditional regulatory approvals) on Shanghai’s Science and Technology Innovation Board (STAR) board in 2019. For the first 8 months of 2020, A-share IPO activity rose 183% year-on-year, with ChiNext and STAR board accounting for 68% of all IPOs.
Virtuous cycle: China’s “Dual Circulation” strategy
At its latest Politburo meeting, China articulated its “dual circulation” development strategy to focus on domestic demand as the main driver, supported by a network of domestic and international circulations that complement each other.
China’s October plenary session for the 14th Five Year Plan (FYP) (2021-2025) will flesh out details on rebalancing the economy from export and investment driven to a domestic consumption-led economy. This reconfiguration is foundational for China’s shift toward self-reliance and hegemony in areas of service, technology, healthcare and “green” infrastructure to facilitate China’s transition into a low-carbon economy.
What does this mean for investors?
1) Include exposure to China in asset allocation of portfolios. China investments (currency, equities, bonds and private market assets) will be an important source of return and diversification, due to the nature of China’s growth and its rising importance in global benchmark equity and bond indices for global institutional investors.
2) Increase exposure to sectors that will benefit from “Dual Circulation” strategy. The policy aims to drive domestic consumption, onshore sourcing and import substitution. With focus on next-generation infrastructure for digitalisation and intelligent ecosystems in public and private sectors, potential beneficiaries include data centres, artificial intelligence, 5G applications, the internet of things, and environmental infrastructure such as electric vehicle charging piles and ultra-high voltage power transmission projects.
3) CNY strength supported by capital market liberalization. Our bullish CNY view is supported by China’s economic sweet spot and inflows into its equity and bond markets. Our 12-month USDCNY forecast is 6.55. The scope for foreign central banks to increase their holdings of CGBs and CNY is high amid a new-zero interest rate environment and a wish to diversify currency reserves away from the USD and EUR. The latest IMF survey data for Q2 2020 shows 61% of reserves globally were held in USD and 20% in EUR while only 2% were held in CNY.
Risks to our view
• Credit Risks: Corporate balance sheets of selected industries have been stressed due to the Covid-19 pandemic. This may put pressure on cash flow and result in rise in credit risks in China.
• Further escalation in US-China relations: Regardless of the US presidential election outcome, US-China tensions will remain elevated with risks of challenging hurdles for Chinese companies seeking to go global.
• Pace of economic recovery: A slower-than expected pace in economic recovery. We forecast China GDP growth of 1.7% in 2020; and 7.1% in 2021 as our base case.Disclaimer applicable to recommendation
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Version: July 2020