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China to Pilot Private Investment Overseas and Financial Reforms: ANZ

03-29 16:36 Caijing
Given China's capital account will be mostly open in 2015, China's private capital outflow is likely have a greater impact on the global economy.

China has approved Wenzhou city to accelerate its financial reforms by allowing residents to invest abroad and encouraging private investment in local financial institutions, according to a State Council announcement posted on a government website yesterday.

We believe this pilot marks an important step towards liberalisation of China's capital account, and if successful, may be rolled out to other parts of the country.

The pilot programme will lead to:

•  Private participation in the state-dominated financial system. This will encourage competition amongst banks and help address the funding problems faced by small and medium-sized enterprises;
•  A push to interest rate liberalisation: in the shadow banking system interest rates are driven by supply and demand;
•  An easing, over time, of the pressures on RMB appreciation through private capital outflows; fast capital account liberalisation implies a flexible exchange rate system; and 
•  A boost to Hong Kong's equity and housing market.


KEY TAKEAWAYS FROM THE WENZHOU PILOT PROGRAMME:

1.  The government will put in place improved systems to monitor private financing activities and associated risks

2.  Encouragement of private capital in setting up or taking shares in rural banks and credit companies

3.  Eligible micro-finance companies could be transformed into rural banks

4.  Private investment funds will also be guided toward the establishment of venture capital and private equity activities, as well as other types of investment bodies

5.  The government will also examine a pilot scheme that will allow the city's residents to make direct overseas investments

6.  The government will encourage qualified state-owned banks and share-holding banks to set up special units to deal with credit grants to small enterprises

7.  The government will also encourage the establishment of financial leasing enterprises that can serve small and micro enterprises, as well as sectors serving farmers, agriculture and the city's rural areas.

8.  Other steps of the pilot programme include:
•  measures to standardise and legalise transactions of non-listed company shares
•  encouraging local bond market development
•  setting up guarantee mechanisms for small and micro companies, and 
•  encouraging commercial insurers to participate in the establishment of a social security system
 
CHINA'S FINANCIAL REFORM TO ACCELERATE

In his address to the National People's Congress (NPC), Premier Wen Jiabao mentioned the launch of a pilot program to encourage private involvement in formal financial system in Wenzhou. However, many thought that any significant reform measures would be delayed given that political stability is viewed as the top policy priority in this leadership transition year. 

Under the current state-dominated financial system, Chinese banks have made limited progress in addressing the financing constraints faced by SMEs.  Allowing for the creation of private financial institutions to engage in SME financing will formalise the private shadow banking system, bringing them under formal financial regulations. 

This important reform measure suggests that the Chinese authorities would like to push forward other long-waited structural reforms this year, with pensions, resource taxes, and factor prices topping the policy agenda. 


INTEREST RATE LIBERALISATION NOT MENTIONED

While private participation in the formal financial sector is encouraged, there was no mention on whether these private financial institutions will have the leeway to set their own rates of interest, especially in terms of deposit rates. 

We believe such measures could be forthcoming as it is difficult to liberalise interest rates in just one limited area of an economy: money will always flow into high-yielding locales, leading to a de facto interest rate liberalisation environment for the whole economy. 

Given the private shadow banking system in Wenzhou city already uses the market interest rate in pricing the cost of funding according to demand-supply conditions, conforming to an interest rate control regime may defeat the purpose of drawing private financial institutions into the formal banking and financial regulatory system. 

PBoC governor Zhou Xiaochuan recently mentioned that the conditions for interest rate liberalisation are almost ripe, suggesting interest rate liberalization is already at the top of the agenda. 


CAPITAL ACCOUNT LIBERALISATION TO ACCELERATE

Allowing private capital to invest overseas is an important step to opening the capital account. This will not only reduce the “home bias”, but also help alleviate financial distortions and inflation pressures. 

As Chinese residents have greater investment options, capital outflow will increase the downside risk in the property market, especially as China's ambitious public housing programme will provide a significant boost to the supply of housing. 

However, Chinese authorities have accelerated QFII approvals and increased the foreign debt quota (FDQ) for foreign banks, both of which will trigger more capital inflows. Indeed, China is now more confident in regulating two-way capital flows, an important experiment towards further capital account openness.

Given that capital account liberalisation is closely linked to interest rate liberalisation and exchange rate flexibility, we expect further financial reforms will be pushed nationwide in order to lessen systemic risks in the financial system. 

Encouraging private capital outflows also means that the pressures for RMB appreciation will reduce over time. And fast capital account liberalisation implies a flexible Chinese exchange rate system at some stage. Given the authorities have been preparing the market and investors for increased two-way volatility of the exchange rate, we still think that the PBoC could enlarge the USD/CNY trading band sooner than expected. 


HONG KONG THE FIRST BENEFIT 

Under the pilot programme, Wenzhou citizens will gain direct exposure to overseas financial assets, bypassing the existing Qualified Domestic Institutional Investor (QDII) program.

Hong Kong will be the first benefit. Currently, Wenzhou holds USD56bn in bank deposits and about USD190bn in housing stock. If just 5% of these holdings flow to the Hong Kong market, it will deliver a significant boost for to Kong's equity and housing market. 

Looking further, Chinese households hold more than CNY37trn ($5.9trn) in bank deposits, and own CNY86trn ($13.6trn) of house stock. If 1-2% of these assets move abroad, the flow will provide a boost to global assets market as well. Given China's capital account will be mostly open in 2015, China's private capital outflow is likely have a greater impact on the global economy. 

While the details of this Wenzhou resident overseas investment program still need to be spelt out, the potential outcomes could be larger than expected. 

Sources: CEIC, ANZ Research

Sources: CEIC, ANZ Research

CONTRIBUTORS
 
Li-Gang Liu
Head of Greater China Economics 
 
Hao Zhou
Economist, China Economics

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