China

Despite setbacks, currency and capital market reforms remain on China's agenda

The Chinese currency will be added to the IMF’s reserve currency basket on 1 October. While Beijing has made only halting progress on many of the reforms that matter for foreign companies, capital account and currency reforms are areas where meaningful progress has been made during the first term of President Xi Jinping. That progress looks set to continue over the next few years. 

Companies looking to invest in China for the long term should take comfort in the fact that Xi and his team have remained committed these changes, even in the face of serious concerns about the health of China’s financial sector and continuous volatility in domestic and global capital markets. As they build toward more open financial markets, these reforms will improve China’s long-term economic health and widen opportunities for foreign investors.

But navigating these reforms has not been entirely smooth. And the incremental pace of change has been frustrating for financial market investors and financial services companies. 

In August 2015 Beijing devalued the currency by roughly 2% against the US dollar in a move meant to facilitate SDR inclusion by aligning the currency’s value with market forces. But the devaluation, which occurred during a steep stock market correction, shocked global markets and provoked a spike in capital flight out of the country. Beijing spent nearly $500bn in foreign exchange reserves as it intervened to stabilize the renminbi’s value through May 2016. The episode undermined confidence in the currency and in China’s capital markets, and the global use of the renminbi fell from 2.4% of global transactions in December 2015 to 1.7% in June of this year, according to data from SWIFT.

But in recent months the outlook on the global use of the currency is brightening: The most recent SWIFT data shows its use recovering to 1.9% of global transactions in July, and it is now the fifth most widely used global currency (after the dollar, euro, pound, and yen). And the currency’s inclusion in the SDR basket should increase demand further; its share of the overall basket will be just under 11%, ahead of the pound and yen. 

The opening of China’s capital markets has also been tricky. Responding to growing concerns about currency depreciation and capital outflows, Beijing ratcheted up its scrutiny of foreign exchange conversions, derailing proposed outbound acquisitions by Chinese firms and raising concern among global companies that currency transactions would become more difficult. The massive correction in stock prices in 2015 also forced the leadership to delay a planned new stock “connect” (trading link) between Shenzhen and Hong Kong, while laying bare the fragility of China’s equity markets. 

This year the outlook is brightening as the Xi administration is putting capital account reforms back on track: it fully opened the domestic interbank bond market for all foreign investors in February, the State Council finally approved the Hong Kong-Shenzhen stock connect in August and the China Securities Regulatory Commission committed to launch it in November. 

These look like modest steps for now. But over time, such initiatives will culminate in a healthier Chinese economy and more opportunities for foreign business. In the financial services sector, for example, there will be new opportunities for insurers and asset managers to offer new wealth management and retirement savings products. Fuller access to these types of products, offered by both domestic and international firms, will lead to better and more robust options for Chinese families to invest and build wealth. More open and vibrant capital markets will also distribute capital more equitably between state-owned and private players and give Chinese families better access to financing for consumer purchases or entrepreneurial investments. 

A more market-based currency will also make trading with China easier. And while market pressure on the currency may be downward in the near-term, over the longer term the renminbi is likely to appreciate. This will mean more affluent consumers with greater spending power. That will accelerate China’s evolution toward a more consumer-based, services-oriented, and sustainable economy over the long term.