Sunday, April 13, 2014

China's Move Is Important For More Reasons Than The Obvious

Alibaba, who? The decision last month by the Chinese e-commerce giant to list in New York presented Hong Kong with an existential crisis. Now that seems like a distant nightmare, after China announced it would link the stock exchanges of Hong Kong and Shanghai and allow a combined $4 billion of daily cross-border trading. It's New York's turn to question the very foundations of its place in the world.

 ($4bn is not much when you consider the actual turnover in Chinese exchanges and HKSE. There are rules of course, its not a free for all, only limited counters are allowed initially. Is the move more to internationalise the Chinese markets? There is some pent up demand as the red chips (the good ones) do trade at a premium in HKSE. Having said that, the view is still strong that China still has to align the accounting and reporting standards to global best practice before a proper valuation matrix can be assumed. This move while good needs to be accompanied by an overhaul of their accounting standards and reporting integrity. Without the latter, any move will only be scratching the surface.)

Yet at the risk of being a party-pooper, I have wonder if this step, coming now, is in China's best economic interest.
It's certainly a godsend for Hong Kong. The former British colony is about to gain the ultimate competitive edge to attract new initial public offerings and money flying out of U.S. markets. Offshore punters will finally be able to act on all those reports they've churned out over the last five years claiming that Chinese stocks are crazy cheap. Mainlanders will enjoy unprecedented trading opportunities, which explains today's massive rally in shares of Hong Kong Exchanges & Clearing. Opportunities abound for arbitrageurs to bet on stocks trading at a discount to A-shares, and vice versa, and for banks hawking volatility products based on mainland markets.

The trouble is, China is putting the cart before the proverbial horse. Sure, capital liberalization is a reform all its own, part of Premier Li Keqiang's pledge of deeper integration with international markets and a greater role for the yuan in global trade. But nothing about this step makes China's government more transparent, its companies more shareholder-friendly, its financial system sounder or the shadow-banking boom any less of a risk to the outlook. 

(The move is tied more to alleviating the liquidity problem in China, or rather too much of it. There are not sufficient assets to go around, which is why, after numerous attempts to deflate property prices there, real estate is still pricey and mostly out of the reach for the common folks. Herein lies also a conundrum, the move will effectively allow hot personal funds to get out of China. Currently for the Chinese to buy overseas properties, there are numerous obstacles in transferring the funds. Thus while this move makes for better movement of hot money, it is not exactly in line with the current clampdown on corruption. I guess its the lesser of two evils.)

Personally, I think China should fix its internal problems before tending to external opportunities.

The question comes down to this: Do you really want your U.S., U.K. or Singaporean pension being invested via Hong Kong into a retail-investor dominated, non-transparent, hugely volatile and corrupt market where the amount of flow in or out is subject to a quota? Limits on how much investors can trade mean that six months from now, when China opens the equity channel, it won't be a capitalist free-for-all. In that sense, this step isn't as tectonic as many investors think.

But it does raise troubling questions about the motive behind capital liberalization. To some, it's about increasing China's global reach and power. To others, like reform-minded People's Bank of China Governor Zhou Xiaochuan, it's a means of forcing through painful, but vitally-needed changes like internationalizing the banking system, prodding state-owned enterprises to improve governance and efficiency and upping the quality of Chinese assets in general. Linking the Shanghai and Hong Kong markets now seems to be of the former variety.

(A bigger problem which I am sure Beijing is aware of is the black market for lending, which is rampant in China. The banking sector there artificially puts out a low interest rate, and the corporate lending structure is fragmented at best. Many listed entities and most private entities have to resort to black market for funding purposes. There are too many inter linked big issues when it comes to hot money, black market lending, the huge debt burden for many state companies and local government offices. It will take a huge blueprint to overhaul the whole thing without disturbing the economic progress and stability of the financial system. At least I think Beijing is taking the right baby steps but there is a lot more things to do, even more important ones such as the "undeclared private debts", the real debt burdens of state companies, engineering more affordable housing without derailing the property market, revamping accounting standards to international levels, etc...)
China should be acting boldly to strengthen its macroeconomic environment, something it can't do while slavishly maintaining a 7.5 percent growth target. Far more energy goes toward meeting that goal than deemphasizing investment and exports and developing a thriving services sector. China needs to build a credible and globally competitive banking sector. At the moment, it's little more than the credit version of a filling station for politically-connected companies. China also needs a financial system that's both stable and trusted.

If looser capital flows outpace domestic reforms, all China is doing here is expanding the transmission mechanisms should its $8.2 trillion economy hit a wall. On April 9, the South China Morning Post warned about Hong Kong's exposure to a mainland debt crisis. The International Monetary Fund characterizes the growth in loans by Hong Kong banks to mainland entities as "rapid" at roughly 19 percent of total assets. The Bank for International Settlements says there are $430 billion in loans outstanding from Hong Kong banks in China. For a $263 billion economy, that's a ridiculous amount of exposure. Compliments of "reformers" in Beijing, it's about to get bigger.

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