China’s Capital Markets Liberalization

Since Deng Xiaoping’s Open Door policy in 1978, China has embarked on a remarkable economic transformation, aiming to enhance its appeal and attract foreign funds into its equity and bond markets. These two markets now have a combined worth of nearly USD20 trillion but are still almost entirely funded by domestic investors [1].

Skeptics have long questioned whether China is serious in its liberalization pledges. China joined the World Trade Organization (WTO) in 2001, promising to open up its markets. In reality, many Chinese sectors are dominated by state-owned entities, making it difficult for foreign firms to compete on equal grounds. After 17 years of WTO membership, the combined market share of foreign banks in China remains below 2%. [2] Arguing that protection of its comparatively young financial industry is necessary, the Chinese government has subjected foreign financial institutions to a number of market access constraints.

Foreign banks were restrained by a maximum stake of 20% for single foreign shareholders and a 25% cap for multiple foreign shareholders invested in local Chinese banks, which is further compounded by business entry requirements. Foreign asset managers could only own up to 49% in a Chinese fund management company.

In the wake of the new Foreign Investment Law (FIL) passed on March 15, 2019, Premier Li Keqiang pledged at the World Economic Forum in July 2019 to abolish foreign ownership limits of securities, futures and life insurance firms by 2020, a year earlier than previously promised. [3] Subsequently, a concrete timeline starting in January 2020 to remove the limits was released by the China Securities Regulatory Commission (CSRC) in October 2019.

Looking back at the past two years, the pace of financial reform seems to be accelerating, from the removal of ownership caps in the banking sector to the relaxation of foreign stake in fund management firms to 51% in 2018. But is this a sustainable trend?

This paper is part of a series which aims to critically analyze these recent advances towards Chinese financial liberalization, highlighting the opportunities while drawing attention to nuances that indicate much work to be done to achieve international standards of mature capital markets. Our first article focuses on the foreign ownership scheme where we seek to understand: what does the recent foreign ownership scheme mean for foreign investors in credible and tangible terms?

Given the current landscape of change as described in the summary opposite, we see several opportunities for foreign investors:

a. Asset Managers: this is a material occasion for foreign asset managers to tap into the lucrative Chinese asset management market (as of August 27th, 2017, the total AUM under the Asset Management Association of China self-regulation is 54.12 trillion RMB [6]). Participation has previously been limited to minority joint ventures. Now, foreign asset managers can own 100% of a domestic asset manager to set up wholly-foreign owned enterprise and apply to operate as private securities fund management businesses.

The benefits of acquiring a Chinese asset management firm are multifold: global asset managers can leverage established operating infrastructure, talent, client base and distribution channels without starting from scratch in an unfamiliar arena. This has now emerged as one of the most tangible routes for global players to enter and operate domestically under full control in China.

b. Banks: one possible shortcut for foreign banks to gain market share in China is acquisition of a distressed bank. Many smaller Chinese banks have strong growth prospects but a weak balance sheet and poor risk management, hence they are substantially more exposed to risks from shadow banking and reliant on high-cost wealth management products for funding [7]. Domestic banks with such a profile could be potential acquisition targets for foreign firms. As laid out by the 11 Measures, foreign financial institutions are encouraged to establish or invest in asset management subsidiaries of commercial banks.

c. Dissemination of Best Practices: the removal of ownership controls will allow for greater flexibility in introducing international standards to the traditionally insular Chinese market. Firms could position themselves well by highlighting tried-and-tested business strategies and best practices to domestic companies still in the growing phase.

d. Innovative and Diverse Offerings: Deregulation promotes a constructive competitive landscape with entrants shaking up the status of domestic incumbents. Currently, the main revenue source of most Chinese brokerages is brokerage fees. [8] As more players join the field and compete for funds, firms will position themselves better by innovating and diversifying into new product and service offerings like margin financing.

While these reforms are a positive step in the right direction, there are significant ambiguity and obstacles behind these regulations, which may become unexpected challenges for foreign financial institutions. This includes [9]:

a. New Qualification Requirements for securities companies: the 100 billion RMB net asset requirement for controlling shareholders and other disclosure requirements are hard to comply with in reality.

b. New Ownership Caps by Non-Financial Firms: China tightened supervision on non-financial institutions investing in the financial sector, which may affect foreign investors disproportionately and require restructuring of existing shareholdings in securities companies.

c. Lack of Clarity for Existing Shareholders: existing shareholders of securities companies who acquired their shares before the new rules come into effect are uncertain whether they will be exempt from complying with the new qualification requirements or have a sufficient grace period to meet the requirements.

d. Failure to Consider Impact of Parent Entities: the regulation does not take into account the parent entities of direct shareholders when assessing compliance with the new qualification requirements.

e. Arduous and Opaque Licensing Process: existing licensing procedures for ownership application have been excessively slow – some foreign firms waited almost a year for a decision on the previous 51% ownership limit. Others claim that Chinese regulators still slow them down by refusing to acknowledge receipt of their application, rather than rejecting it outright, in order not to spark criticism [10].

Furthermore, inconsistent licensing rules contribute to an uneven playing field. This is evidenced from the rule that existing joint ventures can only apply for 2 new licenses every 6 months, while new ones can apply for 4 new licenses in one tranche. To achieve true financial liberalization across the board, more transparency must be provided regarding application procedures, terms and conditions for approval, and timelines for submission of documents and review.

The opening up and structural transformation of the Chinese market is still in its early stage with a lot of uncertainty. This will require global investors to hold a longer-term view and maintain close relationships with local business partners and regulators to evaluate their business strategy in the context of the complexity of the Chinese market. The Chinese capital market is still isolated from global markets due to capital controls, driven by a limited range of financial instruments and restrained short-selling transactions. All of these have limited the variety of potential investment strategies for global players who must tailor their strategy to respect the constraints of such a contrasting market.

Further, the publication of the measures announced by the Chinese government will require relevant regulators to codify the application and approval processes. More detailed implementation rules (such as investor qualifications and application procedures) are expected to be issued to give better guidance on the application process. That said, Chinese financial regulators enjoy significant discretionary power in granting approvals and well-established foreign financial institutions that are well-known to the authorities are perhaps more likely to be granted new licenses and approvals initially.

Finally, the country has repeatedly pledged to ease certain regulations but not followed through in the past, causing some to wonder whether China will push through with its plans this time. Investors will need to closely monitor the upcoming rules since broader opportunities should become available as additional regulatory details emerge.

ERNEST YUEN
Senior Manager, Hong Kong
+852 5664 105
ernest.yuen@sia-partners.com

CLARE TONG

Senior Consultant, Hong Kong
+ 65 9383 6879
clare.tong@sia-partners.com

DOMITILLE MOZAT

Senior Consultant, Hong Kong
+ 852 9706 0206
domitille.mozat@sia-partners.com

1. CEIC China Database

2. World Bank, Percentage of Foreign Bank Assets Among Total Bank Assets for China, retrieved from FRED, Federal Reserve Bank of St. Louis

3. Walker, Rupert. Fund Selector Asia. China plans early end to foreign ownership limits (July 2019) URL: https://fundselectorasia.com/china-plans-early-end-to-foreign-ownership-...

4. Mayer Brown, China Announced "11 Measures" to Further Open Up Its Financial Sector (July 2019)

5. Chang, Evelyn. CNBC. Amid trade war, China moves to remove limits on foreign ownership in the financial industry (October 2019) URL: https://www.cnbc.com/2019/10/14/china-to-scrap-foreign-ownership-limits-...

6. AMAC (Asset Management Association of China) URL: http://www.afca-asia.org/Portal.do?method=memberDetailView&returnChannel...

7. Ehlers, Torsten, Kong, Steven, Zhu, Feng. Bank for International Settlements Working Papers, Mapping shadow banking in China: structure and dynamics (February 2018)

8. Ren, Daniel. South China Morning Post. China to scrap foreign ownership limits in securities, futures and fund management firms next year in apparent trade-war concession (October 2019) URL: https://www.scmp.com/business/companies/article/3032612/china-scrap-fore...

9. ASIFMA, China Capital Markets Report (June 2019)

10. The Economist, Foreign financiers look past the trade war and ramp up in China (July 2019)