The convergence of several issues pressing on China’s economy raise the likelihood for implementation of proposed reforms that could open its financial services markets to foreign companies.
This summer witnessed many developments in the long process of China’s opening to foreign financial services industry (FSI) companies. The changes proposed by Chinese leaders relate to both matters under discussion in the on-going trade talks with the United States, as well as domestic pressures for sustained economic growth and development.
Among the many issues tabled for negotiation in the U.S.-China trade negotiations are allegations that China has not complied with commitments made in its 2001 accession to the World Trade Organization with regard to foreign access to the financial services market. Yet there are also many signs that China’s need for new inflows of hard currency is urgent, and concerns about off-shore borrowing are on the rise.
In mid-July, meetings were convened to refine and ratify a set of eleven reform proposals, which together would open core services in fund management, asset management services, and rating services to foreign-owned entities. More recently, the National Development and Reform Commission restricted new offshore issuance by both Chinese corporates and local government finance vehicles, essentially limiting new issuance to servicing existing off-shore debt. If and when China’s proposed openings of the onshore financial markets are implemented, FSI executives will likely turn some of their attention from regulatory matters to understanding the commercial implications of China’s newly opened financial markets.
The process of issuing the eleven reforms and constraining off-shore borrowing comes at a time of convergence of at least four pressures on China’s economy. These include the U.S.-China negotiations, which continue to see sharp ups and downs; some prominent defaults and other red flags indicating high levels of stress for banks, asset managers, wealth management product providers, and factoring agencies; a continued slowdown in officially-published growth measures; and China’s projected flip sometime in 2019 from being a current account surplus economy to a current account deficit economy (now reflected in a reset of the renminbi (RMB) value below the long-held 7-to-the-dollar line).
These converging pressures add an important measure of credibility and probability to the potential implementation of the proposed financial market reforms. Although the ever-changeable state of trade negotiations is a highly variable factor, given that China’s overall export growth and inbound FDI growth in 2019 has been healthy (notwithstanding the tariffs) the other domestic pressures have been developing for many years and arguably are more urgent.
In fact, throughout the U.S.-China negotiations, China has steadily produced new rules opening its domestic markets to foreign investors. For example, at the very beginning of the trade negotiations, China legislated new foreign investment laws, reduced restricted investment sectors, eliminated quotas for foreign investors licensed to participate in the Qualified Foreign Institutional Investor program and its RMB counterpart, and moved more decisively toward a negative list for foreign investment that promised to open almost all investment areas.
Many details of the proposed provisions remain to be defined, including timing of some components and the extent of certain changes. Yet these watershed announcements could encourage multinational company (MNC) financial executives to focus on several commercial implications and opportunities in China’s markets.
As a starting point, there is no debate over the claim that asset growth in China, the Asia-Pacific region, and other emerging economies has far outpaced mature economies in recent years and will likely continue to do so for the foreseeable future. Several other issues connected with these proposed reforms are important considerations for foreign enterprises.
First, as evidenced by recent events, it has become more evident that some asset values that play widely in traded financial products have little basis in testable value, and as a result, when facing liquidation or debt servicing events, they are unable to meet obligations.
Second, Chinese media has acknowledged the need to improve regulation and supervision of financial services, especially in the realm of Total Social Financing and local government borrowing. Implicit in the invitation to foreign rating firms to enter the China market is an acknowledgement that the quality of information available to investors, both offshore and onshore, could be improved. As the number of defaults increases and as some high profile entrepreneurs are investigated for financial misdeeds, government leaders appear increasingly focused on the economic and social risks of under-regulated financial service activities.
Finally, it is important to note the occurrence of some major problems related to meeting debt service or liquidation events of security assets with inflated underlying asset values. These issues link upstream to enterprises that originate the receivables, real estate, loans, and other assets that are being securitized in the chains. The failures may expose serious implications for the real economy as well.
MNC Strategy and Planning Considerations
Major commercial strategy and planning considerations for MNCs can be organized into five clusters, which are directly reflected in the eleven reforms.
1. Many FSI subsectors, including brokerages, insurance, and information services, will be relieved of equity caps for foreign ownership.
2. An increased appetite for direct and portfolio foreign investment may likely open the door for foreign investment funds and asset managers to play a larger role in supporting both private enterprises and state-owned enterprises deep into a reform process that encourages public-private partnerships.
3. Increased participation of large-scale foreign investment will likely move at least some businesses within China’s largest enterprises into a more commercial, transparent, and sustainable mode of operation.
4. Sharpened competition from world-class foreign financial services companies in the mainland market is likely to benefit all participants, and is likely to broadly accelerate the reform and competitive capabilities of China’s own financial services giants.
5. Foreign rating agencies are invited to rate mainland-based investment products and potentially comment on economic issues that impact the quality of all categories of investment. This is a transformational development, because China has in the past formally restricted measurement and publication roles for foreign entities in China across a broad range of data, from GDP and PMI down to the performance of small and medium enterprises approaching or listed in public markets. Over time, this change alone could engender a major advance in transparency, benefitting investors, regulators, and financial services executives.
These strategic and planning considerations can help FSI executives organize their analyses of opportunities and risks wrought by the eleven reforms. Because these reforms could offer a rich buffet of opportunities, fully envisioning how these eleven measures taken together may contribute to a more open, stable, and transparent investment environment can help MNC executives identify and prioritize optimal operating structures, investment targets, and pursuit tactics.
Notwithstanding the liberalization of financial investment and asset management opportunities from a regulatory standpoint, commercial and information shortcomings are likely to impede the level of inflow China would hope to see. For example, to achieve optimal results from liberalized regulations for inbound financial services, MNC investment executives will likely want to see a significant opening of information sources, improved transparency into and reliability of audited operating results and risks, and other critical inputs into their investment decision-making.
Understanding the motivating forces behind each of the proposed measures explored here can be crucial for foreign entities’ ability to craft a successful value proposition and implementation path forward. For foreign investors, there will likely be many changes in the commercial calculus shaped by new market factors. Yet, even if these important reforms are implemented, China should remain a tightly regulated system overall. Financial regulators, in particular, will likely maintain broad latitude for approvals and for interpretation of rules, to which precise and visible alignment with Beijing and local leadership will likely remain essential for sustainable success in the mainland China market.
―by Joe Guastella, principal, Deloitte Consulting LLP, and Americas leader of the Deloitte Chinese Services Group; and Ken DeWoskin, Deloitte Services LP, an independent senior advisor to the Chinese Services Group.