The scheme is an important step towards an orderly outflow of funds from the Mainland.
There is much discussion about when the "through train" for Mainland individual investors to invest in Hong Kong equity will arrive. The launch of the scheme seems to be taking longer than expected in the earlier press reports, perhaps understandably because the implementation details need to go through a co-ordination process among the regulatory authorities on the Mainland. In any event, I have little doubt that it is in the interest of the Mainland to start the train running. It is important for the Mainland to induce an orderly outflow of capital on a meaningful scale, having regard to the macroeconomic imbalances on the Mainland.
The balance-of-payments surplus of the Mainland is getting bigger and bigger, exerting considerable market, as well as political, pressure on the renminbi to appreciate. With fairly tight capital account controls, and justified concerns over the risk of allowing the exchange rate to appreciate too quickly, the situation has resulted in a rapid and large accumulation of foreign reserves. In monetary policy terms, this means a rapid increase in the monetary base, or the renminbi balances held by commercial banks at the People's Bank of China. In an environment of accelerating inflation, there is a strong need for the monetary effects of the rapid increase in the monetary base to be at least "sterilised". Indeed, monetary tightening seems well justified. The sterilisation is done through successive increases in the reserve ratio, which will rise to 12.5% on 25 September, forcing commercial banks to hold reserves at the central bank, earning fairly low interest, currently 1.89%; and by issuance of central bank bills through which the renminbi injected into the banking system in exchange for foreign reserves are borrowed back by the central bank. The outstanding amount of bills issued by the People's Bank of China for this purpose was RMB 4 trillion at the end of August. The current yield of the one-year central bank bills is about 3% and the paper is mostly held by the commercial banks.
One can of course argue that the reserve ratio could be increased further to sterilise continuing capital inflows, although the ratio is not far below its historical high of 13%. The People's Bank of China can also issue more central bank paper. But either way the effect will be the same: the commercial banks maintaining reserves with the central bank and holding the central bank's paper are forced to accumulate low-yield assets in their books. These low-yield assets obviously will affect the profitability of the banks, and as some have argued, may induce them to take an aggressive stance in corporate and household lending to compensate for the narrowing of the net interest margin. When the economy grows rapidly and bank loans perform well, this may not be a concern. But it would be another story if the general economy were to slow down or a particular sector of the economy were adversely affected by macro adjustment and control measures.
The combination of continuing rapid accumulation of foreign assets and an appreciating exchange rate is problematic in itself. Whether it is booked on the balance sheet of the People's Bank of China or the China Investment Corporation or in the financial accounts of other official entities, the long foreign-exchange position is quite costly to run. This is particularly so because the official agencies that manage these foreign assets have to be accountable to the people and would therefore avoid taking too much risk in the investment of foreign reserves. Complicating the situation further is the dilemma that, while monetary tightening is needed to control accelerating inflation, higher interest rates also risk attracting more of the capital inflows that are causing the problem in the first place.
The solution, quite clearly, is further liberalisation of the capital account. In fact now is a golden opportunity to do so. Understandably, there would be concern over the possibility of illegal outflow of public money and so a tightly controlled mechanism must be established. But there should be much less concern over the outflow of money owned by individuals or private enterprises. It is, after all, their money, particularly when we are talking about foreign currencies already held by them and trapped in bank accounts earning low interest. And so we have the "through train" scheme for individuals to invest in Hong Kong equities, although in my opinion the structure of the scheme still involves too many controls. These controls, no doubt, reflect, among other considerations, the desire of policy makers to protect the interest of individual investors on the Mainland, and this is a reasonable concern.
Protection of investors is obviously an important responsibility of the authorities, but it should be discharged through measures such as disclosure requirements, to ensure that investors have the necessary information to make their own investment decisions, and market regulation, to ensure that the markets are not manipulated for the benefit of a few at the expense of the majority of investors. Hong Kong, being an international financial centre, is possibly at the forefront of investor protection. It is important to remember that stock prices fluctuate, sometimes wildly, and it is always difficult to judge the right entry points. But investors themselves, not the government, should be in the best position to decide when, where and at what prices to invest. To help investors make such decisions, it is important to increase their knowledge about the financial market in which they invest, in this case the Hong Kong stock market. At the initial stage of the "through train" scheme, it may also be helpful to impose a minimum amount of investment or limit access to the scheme to investors in major cities who probably are more aware of the risks involved and in a better position to manage them than other investors in the country.
Being so used to financial freedom, my views are perhaps biased. Some may even think that the scheme is another gift from the central government to Hong Kong. But they are missing the bigger picture. The "through train" scheme will undoubtedly benefit Hong Kong, bringing in more business and helping the development of our financial market, but that is not its purpose. The scheme is about inducing an orderly outflow of capital from the Mainland to help address the issues arising from the large and persistent balance of payments surpluses. It does seem to me that the "through train" is the right step for the country to take to tackle its macro economic problems.
Joseph Yam
20 September 2007
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