China’s growing international importance is a good reason for its markets to be linked to those of the rest of the world.
As readers are aware, Mainland China is now the fourth largest economy in the world in terms of GDP, the third largest trading nation, and the largest holder of foreign reserves. Given that it is also one of the fastest-growing economies, China is of increasing significance on the world stage, whatever way we look at it.
In the area of international finance, China is undoubtedly attracting increasing attention: whether it is China’s exchange rate policy, or developments in its capital market, or how it manages its foreign reserves, financial news from China probably hits the international headlines more often than news from other jurisdictions. This is despite the still relatively low degree of integration of China’s financial system with the global financial system, given exchange controls and other restrictions on access to domestic financial markets.
Recently, a sharp downward adjustment in the A-share market was seen to have triggered similar adjustments in stock markets in both Europe and America, and, some have argued, the unwinding of the yen carry trade. Just how the dynamics work is, to me at least, a mystery, given the immobility of funds between the capital market on the Mainland and those in the rest of the world. Perhaps much of this “contagion” works through market psychology, although it is easier to see why the fall in A-share prices would affect H-shares than, for example, US share prices.
Some have said that, after the long bull run in equity markets worldwide, some adjustment was inevitable, and the markets had, in any case, been looking for an excuse to bring it about. Still, it is interesting that the trigger on that occasion was deemed to come from China, although the increasing concern over the sub-prime mortgage market in the US may have played a role. Whatever it was, the increasing significance of China in international finance is something that investors need to be very alert to, if they are not so already. Hong Kong investors, in particular, should pay much closer attention to financial developments on the Mainland, as the Mainland content of the Hong Kong stock market continues to increase and as our market is now, by far, the principal free market in which foreign investors can achieve significant Chinese exposure.
The increasing significance of China in international finance extends to the undisputedly desirable objective of financial authorities to maintain financial stability. How well a globally important jurisdiction maintains its own financial stability affects financial stability in the rest of the world. It is therefore important not only for facilitating sustainable economic development in China but also for the stability of the global financial system, for China to make its financial markets much more efficient and resilient to shocks.
There are many areas in which improvements can be made and these areas have been quite comprehensively identified, both in the eleventh five-year plan last year and in the National Finance Working Meeting earlier this year. The sudden spike in financial market volatility in late February, originating from the Mainland, serves to underline the importance of these areas for reform. Reform always takes time and, particularly in financial reform, great skill is required to arrive at a consensus among parties with different interests that may be narrower than the domestic public interest of achieving greater financial efficiency, not to mention international interest in maintaining global financial stability.
The partitioning of the capital market into domestic and international segments that are not fungible with each other, as indicated by the price differential between them, greatly undermines the efficiency of the market in its all-important function of price discovery. There is no doubt that the market would be more efficient and prices less spiky if domestic supply and demand were able to interact with international supply and demand to form one bigger market (certainly bigger than the sum of the two) with much greater liquidity.
Joseph Yam
5 April 2007
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