Financial Opening: A Bullish Reform Signal but Not a Game Changer

06 Dec 2017

Good, better, best. Never let it rest. ‘Til your good is better and your better is best. – St. Jerome

 

China announced on 10 November 2017 that it would allow foreign majority/complete ownership of Chinese financial firms within the next three to five years.  The move will essentially grant national treatment to foreign investment in Chinese financial institutions.  It is credit-positive for China’s financial sector, especially the non-depository-taking financial institutions (NDFIs), as it will bring in foreign capital and market discipline to improve the sector’s risk management and corporate governance.

The move is a bullish reform signal.  The timing of the announcement, which came just after October’s five-yearly Communist Party Congress, is intended to reinforce President Xi Jinping’s message of policy continuity with regard to reform and opening-up.  In particular, Beijing announced that:

  • direct or indirect foreign ownership of securities investment companies, fund management companies and futures companies would be relaxed to 51%, with the ownership cap to be scrapped totally after three years
  • foreign ownership limit of 20% on a single entity basis and 25% on an aggregate basis of any Chinese-owned bank and financial asset management company would be removed, and
  • foreign ownership cap on insurance companies that are engaged in the personal insurance business would be raised to 51% in three years and then to be completely removed after five years.

This latest liberalisation move is good news for foreign investors, and many observers even see it as a big step towards China’s capital account liberalisation.  But as I have argued, China’s capital account liberalisation is an asymmetric process – attracting foreign capital to come in but still restricting capital to flow out.  This new move is not a game changer; it is still an asymmetric (a constrained) move towards capital account convertibility.

Nevertheless, it may pave the way for Chinese financial institutions to expand abroad later, which will increase capital outflows and help improve capital account convertibility but still in a controlled manner.  Since joining the World Trade Organisation in 2001, China has continued to pursue a policy of severe foreign ownership restriction on its financial sector.  This has led to criticism of it not playing fairly and raised the risk of retaliation by other countries blocking Chinese financial institutions entering the overseas markets.

Greater openness will likely prompt more injection of foreign capital into China’s financial institutions, improving their capital adequacy and risk management capabilities.  This is in line with the regulatory policy objective since early 2017 of strengthening China’s domestic financial risk management.

Of particular importance is the national treatment of foreign investment in China’s asset management companies (AMCs), which are specialist firms using debt-equity swaps to deal with non-performing loans (NPLs) in the domestic system.  As I argued recently, China’s debt-equity swap scheme is not working properly due to an incentive incompatibility problem between the new equity owners and the debtors that has led to adverse selection and moral hazard.

The problem is that these AMCs, as designated by Beijing to engage in debt-equity swaps to rid the banks of NPLs, are state-bank affiliates.  So the swap is essentially changing the label of the state-owner of the debt from bank to AMC without serious restructuring incentives.  The swap also increases the equity share of state-ownership in the companies, hurting corporate governance.  Under these circumstances, many state firms and banks still see the debt-equity swaps as just another way to save the state companies and socialise bank losses.  As long as this bailout mindset overwhelms the pulse of market discipline, it will remain an obstacle to genuine clean-up of the zombie firms and NPLs.

The new liberalisation move can potentially correct this problem in the debt-equity swaps by injecting market discipline in the AMCs, assuming foreign investors can also buy these state-bank-owned AMCs, and revive genuine restructuring incentives under the swap scheme.  The market discipline impact will be more prevalent if the foreign-invested AMCs other than the state-bank affiliates are allowed to participate in the debt-equity swaps.

Time will tell how well this new financial liberalisation policy will work.  At this point, it is unlikely to be a game-changer as the devil is always in the details of implementation.  China is nonetheless progressing in the direction of economic restructuring and debt-reduction.

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