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Asia-PacificOctober 4 2009

Shanghai steams in

China's ambitions for an international financial centre in Shanghai are now clear. It has staggering market growth and a supportive policy environment, but there are still significant barriers to overcome. If China can realise its ambitions, will it be Shanghai that wins the prize? Writer Geraldine Lambe
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Shanghai steams in

When China's State Council announced in March its intention that Shanghai will be an international financial centre (IFC) by 2020, it barely merited media coverage at home. A shiver went down a few spines in New York and London, however. With Western markets and sensibilities still fragile, and recovery from financial crises and recession a long way off, China's ambition to establish its own IFC was seen almost as a threat to the primacy of the US and Europe in global finance.

With Western financial centres made less attractive by more onerous regulation, big budget deficits, growing tax burdens and cutbacks in public spending, China looks set to be the winner. As Goldman Sachs' chief economist Jim O'Neill puts it: "The crisis has been good for China."

Some observers think the goal unrealistic, not least because they believe the government is still unwilling to let the currency float freely and open up the capital account. A rising currency and capital flight are not political risks worth taking while trying to support exporters and grow domestic consumption, they argue. And without these fundamental steps the IFC goal will remain a dream.

But a raft of recent developments suggests that Beijing means business - and indicate that 2020 is an implicit deadline for the liberalisation that the West has long clamoured for.

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Yifan Hu, chief global economist with Citic Securities International in Hong Kong

International status

In September, the finance ministry announced a plan to sell Rmb6bn ($879m) of bonds in the international markets to improve the "international status" of the renminbi and to help mainland companies raise funds in the offshore bond market.

Earlier steps in this drive to internationalise the currency have seen almost $100bn of renminbi swap lines established (with South Korea, Hong Kong, Malaysia, Belarus and Argentina) in only six months. And since December 2008, the State Council has also set up pilot schemes to enable five Chinese cities (Shanghai, Guangzhou, Shenzhen, Donguan and Zhuahai) to settle trade payments with Association of South-east Nations members in renminbi. Both developments are seen as real steps towards full renminbi convertibility.

Yifan Hu, chief global economist with Citic Securities International in Hong Kong, says that against the background of recent events, the State Council's announcement about Shanghai constitutes a statement of intent. "We now have a very clear path - beginning with trade settlement," she says.

At the International Capital Conference in London in mid-September, Liu Guangxi, director-general of the capital account management department at the State Administration of Foreign Exchange, hinted that 2020 would not be an unrealistic deadline. He compared China's progress to that of the UK. "The UK began to liberalise its currency in 1945. By 1978 it had a fully convertible currency. We began in about 1980, so you can project from that what is our likely timeframe."

There are further indications that China is opening its markets. Last month, Beijing announced that it would start allowing foreign companies to list in China for the first time, albeit under a different listing regime. While it will be some time before its foreign listings can challenge the 618 on the London Stock Exchange, allowing foreign firms to raise capital in the domestic market is a watershed moment. HSBC and several other international companies are said to be in early talks with regulators.

According to Z-Ben Advisors, a Shanghai-based boutique consultancy specialising in Chinese investment, Beijing is also steadily increasing the number of foreign firms approved to invest in the Chinese market under its Qualified Foreign Institutional Investor programme by about four firms every six weeks, even if the scheme is currently capped at $30bn.

Staggering growth

Compared with developed financial centres, China's capital markets are immature and opaque. Moreover, there have been plenty of previous plans that have come to nothing. Shanghai built a financial futures exchange nearly three years ago but trading has yet to begin. Other non-events include the launch of stock index futures trading and last year's announcement that Beijing would introduce limited short selling and margin trading; both have failed to materialise.

That said, the growth is staggering. In terms of market capitalisation, the Shanghai Stock Exchange is already the third largest stock exchange in the world, behind New York and London. According to data from Quam Capital, the corporate finance subsidiary of China-focused financial services firm Quam Group, in terms of total capital raised year-to-date, it is a growing challenge.

"China's capital raising capacity is growing at a phenomenal rate," says Richard Winter, deputy chairman of Quam Group. "In terms of initial public offering funds raised year-to-date, Shanghai is beating any other exchange in the world. In terms of total funds raised in 2009 to date, Shanghai is ahead of New York. In fact, if you combine Shanghai with Hong Kong, it is nudging London's number one position."

China's debt markets are also expanding quickly. In 2008, corporate bond issuance almost doubled to nearly Rmb900bn, bringing total outstanding debt to Rmb1268bn, up 66% from the end of 2007. According to data from Thomson Reuters, debt offerings for Chinese companies amounted to $84.9bn in the year to August - nearly three times the volume of issuance in the same period last year. Three banks, China International Capital Corporation (CICC), Industrial and Commercial Bank of China (ICBC) and Citic, accounted for about 45% of the market.

Neil Ge, chief executive of Credit Suisse Founder, the Beijing-based Chinese joint venture with Credit Suisse, believes that China's bond markets are developing faster than is perceived outside the country.

"Yield curves for government bonds are beginning to look more and more like those of mature capital markets," he says. "And the bond markets are expanding both in terms of new issuers and in terms of turnover; they are growing by about 50% year on year. It's true that by historical convention companies have relied on bank funding, but the government and regulators are taking steps to encourage a move to capital markets-based financing."

Government push

In January this year, the China Banking Regulatory Commission announced that it would allow foreign banks to trade and underwrite corporate bonds in the country's interbank market. In May, Standard Chartered became the first foreign bank to trade short-term corporate bills, with tenures of up to one year.

Not only does this open up new business for foreign banks - which were previously restricted to trading government bonds, central bank bills and bank bonds - but it promises to increase bond market liquidity, introduce more diverse trading strategies into the corporate debt market and broaden the investor universe.

Also in January, the central bank said it will scrap the minimum size requirement for interbank-market bond sales, creating a new route for smaller companies with more modest funding requirements to borrow money.

Mr Ge, who in a previous role was responsible for setting up Bank of China's fixed-income division, acknowledges that while there is a nascent convertible bond market and a few other derivative-type products such as bonds with detached warrants, China lacks sophisticated hedging products. But here, too, the government is trying to plug the gaps, he says. "We do not have any real hedging products for issuers or investors, but the government is planning bond index futures in addition to stock index futures."

Stock index futures - promised, but yet to appear - are still in testing, says Mr Ge. "The crisis made the government more cautious," he adds.

Ten years ago, when Shanghai set out similarly ambitious goals, they were unrealistic, but a lot has changed in the past decade. China has a large number of big companies operating on a global scale and, according to one mainland banker, about 300 companies currently queuing up to issue an initial public offering in Shanghai. It has a vast population with an enormous savings pool. The city has been transformed and its stock market outstrips that of Tokyo.

China now boasts several of the world's largest banks, all well capitalised and purged of non-performing loans. They cannot yet compete with foreign investment banks in terms of advisory, but in the bond markets, Chinese banks are beginning to take a bigger slice of the action right across Asia, helped along by the government's $585bn stimulus plan. According to data from Bloomberg, three of China's Beijing-based banks, CICC and ICBC and Bank of China, are all among the top 10 bond houses in the region for the first time this year. They led underwriters with $39bn of debt sales, or 12% of the total in the Asia-Pacific region.

CICC is the region's second biggest underwriter, with 5.7% share of the Asia-Pacific market, behind Nomura with 8.6% market share. Just one year ago, CICC ranked 39th. ICBC has risen to eighth from 21st a year ago, and Bank of China is placed 10th, up from 57th a year ago.

Government intervention

But despite impressive growth and the increasing clout of the country's banks, market discipline does not yet exist. The government continues to exercise huge influence on the allocation and pricing of financial resources through administrative intervention. This affects the assessment of risk, reduces pricing flexibility and generally limits the beneficial effects of market discipline.

Market norms are quickly set aside when the administration sees fit. At the height of the financial markets crisis, volatility in the equity markets prompted regulators to step in and shut down the primary equity markets for fear that investments would turn sour and investor anger would explode into social unrest.

The market for corporate bonds remains highly segmented. One Chinese banker at a foreign firm described a "virtual turf war" between the various regulatory bodies that oversee them.

Short-term bonds with a maturity of one year or less are issued under the aegis of the People's Bank of China and traded over-the-counter (OTC) on the interbank market. Medium-term and long-term corporate bonds (of five to 10 years) issued by major unlisted state-owned enterprises under the auspices of the National Development and Reform Commission and guaranteed by a major state bank are traded on the Shanghai Stock Exchange. Non-guaranteed medium- and long-term bonds, issued by listed companies under the auspices of the China Securities Regulatory Commission, are traded OTC on the interbank market. There is an urgent need for the consolidation of the corporate bond market and its supervision.

Legal challenges

China's opaque and unpredictable legal and regulatory framework will also be a serious hurdle. "Without the establishment of the rule of law in China, including an independent judiciary and government transparency, an internationally competitive financial centre is not possible," says Andy Rothman, China strategist at CLSA Asia-Pacific Markets.

Securities and company law is still way behind that of other financial centres. One problem is the process. First regulators issue broadly defined regulations; it is then interpreted by market participants until such time that regulators issue more detailed guidelines, which are frequently at odds with previous interpretations. This makes regulatory evolution slow, business decisions unpredictable and commitment to a market problematic.

Things are improving, but slowly, says John Hartley, a partner at White & Case in Hong Kong. "The law lags behind the structures that people are trying to achieve. The government is unlikely to change the process, but it is clearly making real attempts to fill in the gaps."

The gaps are still significant. Fear of capital flight and competition from foreign banks mean that new laws continue to favour domestic firms over foreign firms, as foreign banks found out when loans to Ferrochina were wiped out after the company went into administration last year. The 2007 insolvency law does little to protect offshore investors, and the offshore holding structure used to access Chinese companies has proved better at letting money into China than getting it out. When it comes to compensation, foreign lenders are relegated to the rank of equity holders, with any recovered monies going first to onshore creditors.

Despite the most punitive punishments, cronyism and corruption - often at the highest levels - remain a stubborn problem. In the past three months alone, the heads of two large SOEs have been severely punished for taking bribes. Chen Tonghai, former chairman of China Petrochemical Corporation, was given a suspended death sentence for accepting bribes of more than Rmb195m; Li Peiying, former chief of Capital Airports Holding Company, was executed in August for taking Rmb26m and misappropriating Rmb82.5m.

"Such high-profile cases reveal the government's determination to deal with problems but they also highlight the prevalence of corruption in Chinese business. There are plenty of rules to regulate SOEs and to monitor local government officials, as well as random inspections, they just don't work. Corruption is not unique to China, but here it is endemic," says one China-based lawyer.

What's wrong with Shanghai?

The challenge to China's ambitions may be more fundamental. While its leaders have so far managed to successfully weld capitalist-style models to a communist administration, they may not be able to continue this magic trick for ever. Some argue that the holes in the model are already evident - and that this is a particular problem for Shanghai.

Yasheng Huang, professor of political economy and international management at the Sloan School of Management, Massachusetts Institute of Technology, questions the idea that China has been gradually moving towards a free market economy.

In his book Capitalism with Chinese Characteristics, published in 2008, Mr Huang argues that while the 1980s saw significant reform and the emergence of a vibrant rural entrepreneurial class, many of the most productive reforms have been partially or completely reversed. The 1990s saw the beginning of urban bias, huge investment in state-allied businesses, and the courting of foreign direct investment by restricting indigenous capitalists.

Shanghai epitomises these trends, he says. Trumpeted as the most capitalist place on earth and therefore the natural home for international financial services in China, Mr Huang suggests that instead much of what is perceived as evidence of bottom-up entrepreneurialism is in fact Shanghai government-controlled capitalism.

Mr Huang cites some persuasive facts and figures. For example, indigenous private-sector businesses in Shanghai are among the smallest in the country, and their income per capita is about the same in Shanghai as it is in provinces such as Yunnan, where gross domestic product (GDP) per capita is about 10% to 15% of that in Shanghai. Although aspiring to be a high-tech hub of China, in 2005 Shanghai had only 2222 individual patent grantees, compared to 14,333 in Zhejiang and 24,732 in Guangdong. In nearby Zhejiang province, GDP growth and personal income growth have tracked each other; in Shanghai, GDP has increased massively relative to the national mean, but the household income level relative to the national mean has experienced almost no growth. While there is a rich Shanghai elite, since 2000, the poorest segment of Shanghai's population has lost income absolutely during a period of double-digit economic growth.

"At its core, Shanghai is substantially state-controlled and state-led. Its private sector is very underdeveloped. Personal income has not grown nearly as fast as the GDP of the city," writes Mr Huang.

Need for SME engine

If Mr Huang's figures are correct, it may force a reassessment of the basis for China's economic dynamism, but does it make any difference to Shanghai's (and China's) aspirations? Yes, says Mr Huang, because the most significant ingredient in the making of a successful capital market is a vibrant entrepreneurial base. A capital market exists to serve the needs of entrepreneurs, not the other way around, he says.

At the International Capital Conference in September, Dr Fang Xinghai, director-general of the financial affairs department for the Shanghai Municipal Government, agreed that more needed to be done to support the small and medium-sized enterprises (SMEs) sector in China, not least to help generate the domestic consumption needed to balance the country's economic model.

"SMEs are not well financed by China's financial system but we need millions of SMEs to provide the consumption that will drive up domestic demand. Income distribution is a continuing problem and has become more unequal over the past decade. The best way to improve income distribution is to have millions of SMEs driving the economy," says Mr Fang.

Getting away with it

According to the World Economic Forum's global competitive index, China is in the transition stage between the first and second stages of its three-stage development model. Some economists argue that China has managed to make its political-economic model work while the country has been in the earliest stage of economic development. However, it will make it hard for China to complete the move to the second stage, efficiency-driven economy, let alone get to the third stage of an innovation-driven economy.

Stephen Green, head of research for China at Standard Chartered in Shanghai, agrees that state-led growth will make the development of a vibrant service-based economy more problematic; and that is where the future growth of Shanghai (and China) will come from, he says.

"The service sector is state-owned, and that will make it difficult for the 'flora and fauna' that characterises every vibrant economic and financial centre to emerge. Unless Shanghai opens up the service sector to competition, it will not be able to encourage the development of the venture capitalist and private equity communities and the service providers that help to create a financial centre," says Mr Green.

He adds that China's state-led capitalism has led to a misallocation of resources, already evident in poor quality real estate, badly planned infrastructure and overcapacity in industrial sectors such as steel. "China has got away with these levels of investment because other growth drivers have been doing so well, but to move to the next stage of economic development, it must open up further to competition," says Mr Green.

But not everyone subscribes to Mr Huang's critique of China's progress towards a market economy. "China's economy has changed beyond all recognition in the past 25 or so years. It is unrealistic to expect it to make changes more quickly - especially considering it has had to go through the Asian crisis and this latest financial crisis," says Quam Capital's Mr Winter.

While he has not read Mr Huang's book, CLSA's Mr Rothman also says he does not recognise this view of China or Shanghai. "If you look at how the country has changed and developed over the past one or two decades, it is difficult to criticise what the Chinese government has already achieved. The Chinese are careful students. They have learned the lessons of history and from other countries which made the transition too quickly to a market economy. They are determined not to make the same mistakes."

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On the rise: Shanghai's plans to become an international finance centre will be a cause of concern for New York and London

Shanghai vs Beijing

While commentators have couched Shanghai's IFC goal in terms of competition with Hong Kong, and more long term with New York and London, its most dangerous rival is Beijing. Shanghai's aspirations are in Beijing's gift, and the age-old competition between these two great cities is as keen as ever.

Beijing's own financial centre ambitions can be measured by the gleaming head offices that line 'Financial Street' in the heart of the city. China's largest SOEs, its biggest banks, its regulators and all the foreign investment banks are headquartered to here, not in Shanghai. In a country where policy makers still play a pivotal role in every area of business and finance, it is the obvious place to be.

"Shanghai is for show, Beijing is the real money centre and where all the decisions are made. I don't think that will change now," says one Chinese banker in his office on Financial Street. "Shanghai will still be a financial centre, but it will be about trading, clearing and settlement."

There are other financial centres. Near Hong Kong, Shenzhen focuses on the small to medium-sized sector, for example. More recently there has been heavy investment in Tianjin - a major seaport serving Beijing and a logistics and manufacturing hub.

Quam Capital's Mr Winter suggests that it is Beijing's desire to dilute the power and independence of Shanghai which lies behind its decision to push Tianjin as a third mainland financial centre. "Beijing has funnelled huge investment into the development of Tianjin as a financial centre for the OTC market," says Mr Winter.

The aim for Tianjin is to allow investors to trade the unlisted securities of public companies. Pi Qiansheng, a senior official charged with developing the surrounding industrial Binhai region, says there is a plan to create a technology exchange modelled on New York's Nasdaq.

Fragmentation

Other countries have more than one financial centre. The US has capital markets in New York, derivatives in Chicago, technology bankers in San Francisco and a fund management hub in Boston, for example; but its undisputed king of international capital is New York. Many argue that there is plenty of room in China, a nation of more than 1.3 billion people, for more than one financial centre. But China is not the US. The US government did not decree where its financial centres should be; they evolved. The US's rules and regulations are set by independent regulators and an independent judiciary.

Some argue that as China's free market model takes over, the gravitational pull of Beijing's policy makers will lessen. But once a centre has formed and liquidity has pooled, it is difficult to shift. Witness the failure of Paris and Frankfurt to steal London's financial crown.

Citic International's Ms Hu believes China is big enough to have specialised centres - the problem could lie in how that would fragment an already limited talent pool. "One of China's biggest challenges is the lack of enough trained professionals to support growth. There is already a lot of competition between Shanghai and Hong Kong. If competition intensifies, or extends to include Beijing, this could be damaging," says Ms Hu.

Growing an indigenous talent pool takes time. And attracting talent from overseas is not as easy as one might imagine, not least because of China's 45% tax rate - the highest personal income tax rate in the world. "While GDP growth has averaged 9% to 10% for about 20 years and incomes have increased, the share of personal income as a percentage of GDP has decreased by about 1% per year in the same period. This means that wealth creation has benefited government and corporations more than individuals," says Ms Hu.

Shanghai is already planning to introduce a tax subsidy by the end of the year - paid for by local government - for foreign nationals, which would reduce income tax to about 25%. It hopes this will help to make the city more attractive to foreign professionals.

What the local population will think of this is another matter.

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