Views on improving the integrity of global capital markets
14 May 2015

To Reform Chinese Capital Market, Is Government ‘Cooking a Frog in Warm Water’?

Since December, I’ve been blogging about various aspects of the Chinese capital markets — shadow banking, insider trading, the service sector — all with an eye to determining what the Chinese government’s approach to reform would be.

A post about my encounter with a real-life Chinese shadow banking investor triggered quite a bit of comment, and led to two more posts that look at how demographic dynamics and evolution in the service sector fuel the development of Chinese shadow banking. Subsequent to this, I examined tell-tale signs that may reveal the position of the Chinese authority with regards to capital market reform. And, with the luxury of hindsight, most recently I offered additional evidence to validate the strong stance taken by the Chinese authority on issues such as insider trading.

To wrap up this series, it’s now time to take a good look at what other measures the Chinese government has taken, is likely to take, and the probable impact on various stakeholders within the Chinese capital market.

Cooling Measures

First, the central government has delivered a series of cooling measures on the property market. To a large extent, prices in overheated regions such as Wen Zhou, outlying areas in Shanghai, and Guangzhou have responded relatively well to the decline, albeit with lower transaction volume. It is not in the interest of any political party to allow property prices to rise to a point where they are unable to control the ultimate plunge. Henceforth, the cooling measures are expected to remain for the foreseeable future. On the other hand, unless things truly get out of hand, we do not expect additional draconian measures to further cool down the market because a sharp drop in property prices would create a sense of resentment among existing real estate owners — a scenario that the ruling mandate will try their very best to avoid.

Savings Rates

Given the previous one-child policy and the aging population, the subsequent drop in the savings rates is largely irreversible. The only remaining trump card is education, that is to restructure the high school examination system to churn out graduates that can add more value to the physical job sectors. Once successfully deployed, this will go a long way towards improving labor productivity, leading to higher and more sustainable levels of economic growth.

“Cooking a Frog in Warm Water”

It is well known that, throughout Chinese history, any heavy-handed draconian measure to unplug an inefficient economic system will incur the wrath of many vested parties. On the other hand, attempts at incremental change seldom work as well. Typically, the balanced approach is to keep, but isolate, the existing inefficient system while simultaneously building up another one to slowly take control. This approach, referred to colloquially as “cooking a frog in warm water,” is well known among the Chinese population.

It most probably explains why, when Alibaba largely bypassed the entire banking system to raise funds through its in-house distribution platform, regulators were muted in their response. In addition, the speed with which the Shanghai-Hong Kong Stock Connect (SHSC) was implemented is another tell-tale sign that the Chinese government is adamant about shaking up the not-so-efficient capital market this time around.

Reform aimed at opening up the capital market such as the SHSC is nothing new. Before it, we had the Hong Kong and mainland China mutual recognition (HKMR) program, proposed in January 2013. Thus far, however, no concrete deployment steps have been confirmed. The reason likely rests with one key philosophy practiced by Chinese rulers for thousands of years — the need to proceed with caution.

Relative to the SHSC program, HKMR covered a much larger scope, which the Chinese authorities feel is too risky to launch at present. As such, the SHSC program serves as a testing ground for capital market regulators to understand whether the merits of having a more open capital market truly outweigh that of a highly regulated capital market. Once the SHSC program proves to be synergistic with enhancing market efficiency, we would expect the momentum in other similar programs to gain traction.

Shift to Service-based Economy

Fourth, the Chinese authority is currently laying the foundation for the inevitable shift towards a more service-based economy. Given the labor-intensive nature of service industries, small and medium-sized enterprises (SMEs) typically form the backbone of this sector during inception. It is therefore pertinent for the Chinese government to establish a strong and stable funding mechanism to support the SMEs. Plausible steps would include full privatization of certain regional banks that do not carry too much systemic risk, the setting up of a centralized collateral exchange for SME banking, and the restructuring of key performance indicators (KPIs) of senior bankers to motivate them towards serving SMEs.

Against this background, the SHSC scheme is definitely a good move forward, but it is still not a full solution. For the Chinese capital market to gain traction in terms of efficacy and efficiency, banks will need to compete. The same goes for financial institutions that, for a very long time, have remained protected within an invisible cartel. For that, the Chinese regulators are actively exploring global best practices for guidance. However, we would also need to bear in mind that what works for the rest of the world may not work for China, at least for the time being.

As for the common questions regarding when Chinese bourses’ market caps will exceed that of the US, and whether RMB will ever overtake US dollars as the world reserve currency, many of us within the industry seem to have forgotten that such symbolic achievements are currently not on the top of the list for Chinese leaders. Instead, the most pressing issues are coming up with implementable solutions that would enhance the standard of living for China’s 1.4 billion residents.

The job will probably not be accomplished within President Xi’s era, just as it took five generations of emperors (from the Zhen Guan era of Emperor Li Shiming to the Kai Yuan era of Emperor Li Longji) during the Tang Dynasty to accomplish China’s claim as the one and only near-utopia in its 5,000 years of civilization. In the end, only time will tell whether China can once again achieve it. For now, things are surely improving and, as stakeholders in the Chinese capital market, it would behoove us to get in line with the ruling mandate’s preferred direction of reforms.

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Image Credit: Jane Waissman

About the Author(s)
Alan Lok, CFA

Alan Lok, CFA, was a director of capital markets policy at CFA Institute. He was responsible for conducting research projects in the area of market instruments and market structures in the Asia-Pacific region. Mr. Lok worked with regulators, institutional investors, academics, and various other stakeholders within the financial industry to uphold investor protection and market integrity.

2 thoughts on “To Reform Chinese Capital Market, Is Government ‘Cooking a Frog in Warm Water’?”

  1. Joshua Wu, CAIA says:

    Thanks for the insightful article Alan – agree that overtaking the US as the world’s top reserve currency is not in their agenda but they are taking big steps towards that as the IMF is already conducting a comprehensive assessment over the RMB to decide whether the currency will be included in the SDR currency basket.
    Amongst other more obvious perks such as global prestige and lower borrowing costs , the SDR status would represent endorsement from the IMF and indeed the world for China’s reform efforts. Cant see Xi Jinping arguing with that
    Have a similar opinion with you on the cooling measures – it cannot be too drastic in fact they have already taken steps to roll back some of these esp in top tier cities like Shanghai(Shanghai sub property index up >40% ytd!) as they reduced minimum down payments for buyers of second homes and cut to two years a seller owned the home in order to avoid paying a business tax.
    What are the other similar programs to the SHSC that you think they might move into once they achieve their objectives there? Can only think of the Shenzhen-HK connect at the moment which has a substantial no of stocks trading over 400 times PE!

  2. Alan Lok says:

    Once again, thank you Joshua for your ever enthusiastic feedback. We believe regional players (bourses) are watching the development of the SHSC actively and, if the end results are promising, don’t be surprised to see such connections becoming a regional phenomenon in the near future. In any case, the accompanying cross-border enforcement would be a contentious issue if that day were to arrive.

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