China’s Wealth Effect

Considering China’s restrictions on foreign investment in the country’s capital markets, it is little surprise that few people appreciate the sheer size of those markets. The only way outsiders can make anything close to a direct investment in Chinese equities or bonds is through Hong Kong-traded instruments or the few Chinese American Depository Receipts listed on US exchanges.

The Chinese equity market is still relatively small, with a capitalization of about $5 trillion. That’s a lasting legacy from when the country’s stock exchange was shut down following the founding of the People’s Republic of China in 1949 and not reopened until 1990. The country’s domestic bond market, on the other hand, is valued at about $4 trillion, a hefty figure.

True, the country’s bond market is smaller than its equity market. But at $4 trillion, it’s the fourth-largest bond market in the world, behind the US, Japan and France, and growing by nearly 30 percent per year.

There are indications that the Chinese government will begin taking a new tack on foreign investment sooner rather than later, though on the Chinese timeline sooner could still be a matter of years. That’s especially true as the government must first address larger structural issues.

Next month will bring the third plenary session of the 18th Central Committee, a meeting during which a package of key economic reforms is to be discussed.

Those reforms are expected to include measures such as the central government taking over social security and some health care spending from local governments, to strengthen the country’s social safety nets. The central government might also begin allowing local governments to begin issuing bonds similar to US municipals rather than relying on more short-term funding vehicles.

Also on the agenda are plans to reform the country’s system fo! r pricing commodities and other resources and ease the household registration system to allow more rural families to move into the cities.

But most importantly for investors, there are signs that Beijing wants to move forward with market-based interest rates and the loosening of capital controls, making it easier to move money in and out of the country. The government has already taken a tentative step in that direction, announcing a free-trade zone in Shanghai in September that will act as a proving ground for more free-market policies.

In the free-trade zone there are more relaxed investment and capital controls in place, including yuan convertibility, freer investment in Shanghai securities and futures markets and the freedom of foreigners to directly trade in local securities.

These plans come at a critical time for the Chinese economy.

It’s no secret that the country is battling a substantial debt problem after it kept interest rates too low for too long, a familiar problem. As a result, China’s state-owned enterprises were able to leverage up their balance sheets using cheap loans which the government basically required state-owned banks to make. It also helped to drive yet another boom in real estate speculation.

That pushed up China’s credit-to-gross domestic product (GDP) ratio to about 220 percent over the past few years, with credit now accounting for more than a third of GDP. At the same time, all of that lending spawns opportunities for raging corruption, particularly at the local government level.

When the central government assumes more of the responsibility for social spending, serious deficits at the local level will eliminate many opportunities for corruption. That’s because localities are heavily reliant on real estate taxes and short-term funding vehicles. The measures will also help slow credit growth in China, ultimately helping to reduce the country’s debt burden.

Loosening foreign investment restrictio! ns will a! lso help spur Chinese economic growth which, while on track to meet the government’s 7.5 percent growth target this year, has been slowing of late. Foreign investment will be a critical component of growth in the years to come, as China’s economy becomes more consumer focused, helping to stimulate spending through a wealth creation effect.

So, one day sooner rather than later, foreign investors may be able to have more direct asset to a securities market valued at nearly $10 trillion, creating more wealth for the Chinese and everyone else.