Capital Markets and Portfolio Investment
China’s leadership has stated that it seeks to build a modern, highly developed, and multi-tiered capital market. Since their founding over three decades ago, the Shanghai and Shenzhen Exchanges, combined, are ranked the third largest stock market in the world with over USD11 trillion in assets, according to statistics from World Federation of Exchanges. China’s bond market has similarly expanded significantly to become the second largest worldwide, totaling approximately USD17 trillion. In 2020, China fulfilled its promises to open certain financial sectors such as securities, asset management, and life insurance. Direct investment by private equity and venture capital firms has increased but has also faced setbacks due to China’s capital controls, which obfuscate the repatriation of returns. As of 2020, 54 sovereign entities and private sector firms, including BMW and Xiaomi Corporation, have since issued roughly USD41 billion in “Panda Bonds,” Chinese renminbi (RMB)-denominated debt issued by foreign entities in China. China’s private sector can also access credit via bank loans, bond issuance, trust products, and wealth management. However, the vast majority of bank credit is disbursed to state-owned firms, largely due to distortions in China’s banking sector that have incentivized lending to state-affiliated entities over their private sector counterparts. China has been an IMF Article VIII member since 1996 and generally refrains from restrictions on payments and transfers for current international transactions. However, the government has used administrative and preferential policies to encourage credit allocation towards national priorities, such as infrastructure investments.
Money and Banking System
China’s monetary policy is run by the People’s Bank of China (PBOC), China’s central bank. The PBOC has traditionally deployed various policy tools, such as open market operations, reserve requirement ratios, benchmark rates and medium-term lending facilities, to control credit growth. The PBOC had previously also set quotas on how much banks could lend but ended the practice in 1998. As part of its efforts to shift towards a more market-based system, the PBOC announced in 2019 that it will reform its one-year loan prime rate (LPR), which would serve as an anchor reference for other loans. The one-year LPR is based on the interest rate that 18 banks offer to their best customers and serves as the benchmark for rates provided for other loans. In 2020, the PBOC requested financial institutions to shift towards use of the one-year LPR for their outstanding floating-rate loan contracts from March to August. Despite these measures to move towards more market-based lending, China’s financial regulators still influence the volume and destination of Chinese bank loans through “window guidance” – unofficial directives delivered verbally – as well as through mandated lending targets for key economic groups, such as small and medium sized enterprises. In 2020, the China Banking and Insurance Regulatory Commission (CBIRC) also began issuing laws to regulate online lending by banks including internet companies such as Ant Financial and Tencent, which had previously not been subject to banking regulations.
The CBIRC oversees China’s 4,607 lending institutions, about USD49 trillion in total assets. China’s “Big Five” – Agricultural Bank of China, Bank of China, Bank of Communications, China Construction Bank, and Industrial and Commercial Bank of China – dominate the sector and are largely stable, but over the past year, China has experienced regional pockets of banking stress, especially among smaller lenders. Reflecting the level of weakness among these banks, in November 2020, the PBOC announced in “China Financial Stability Report 2020” that 12.4 percent of the 4400 banking financial institutions received a “fail” rating (high risk) following an industry-wide review in 2019. The assessment deemed 378 firms, all small and medium sized rural financial institutions, “extremely risky.” The official rate of non-performing loans among China’s banks is relatively low: 1.92 percent as of the end of 2020. However, analysts believed the actual figure may be significantly higher. Bank loans continue to provide the majority of credit options (reportedly around 60.2 percent in 2020) for Chinese companies, although other sources of capital, such as corporate bonds, equity financing, and private equity are quickly expanding in scope, reach, and sophistication in China.
As part of a broad campaign to reduce debt and financial risk, Chinese regulators have implemented measures to rein in the rapid growth of China’s “shadow banking” sector, which includes wealth management and trust products. These measures have achieved positive results. In December 2020, CBIRC published the first “Shadow Banking Report,” and claimed that the size of China’s shadow banking had shrunk sharply since 2017 when China started tightening the sector. By the end of 2019, the size of China’s shadow banking by broad measurement dropped to 84.8 trillion yuan from the peak of 100.4 trillion yuan in early 2017. Shadow banking to GDP ratio had also dropped to 86 percent at the end of 2019, yet the report did not provide statistics beyond 2019. Foreign owned banks can now establish wholly-owned banks and branches in China, however, onerous licensing requirements and an industry dominated by local players, have limited foreign banks market penetration. Foreigners are eligible to open a bank account in China but are required to present a passport and/or Chinese government issued identification.
Foreign Exchange and Remittances
While the central bank’s official position is that companies with proper documentation should be able to freely conduct business, in practice, companies have reported challenges and delays in obtaining approvals for foreign currency transactions by sub-national regulatory branches. Chinese authorities instituted strict capital control measures in 2016, when China recorded a surge in capital flight. China has since announced that it would gradually reduce those controls, but market analysts expect they would be re-imposed if capital outflows accelerate again. Chinese foreign exchange rules cap the maximum amount of RMB individuals are allowed to convert into other currencies at approximately USD50,000 each year and restrict them from directly transferring RMB abroad without prior approval from the State Administration of Foreign Exchange (SAFE). SAFE has not reduced the USD50,000 quota, but during periods of higher-than-normal capital outflows, banks are reportedly instructed by SAFE to increase scrutiny over individuals’ requests for foreign currency and to require additional paperwork clarifying the intended use of the funds, with the intent of slowing capital outflows. China’s exchange rate regime is managed within a band that allows the currency to rise or fall by 2 percent per day from the “reference rate” set each morning.
According to China’s FIL, as of January 1, 2020, funds associated with any forms of investment, including profits, capital gains, returns from asset disposal, IPR loyalties, compensation, and liquidation proceeds, may be freely converted into any world currency for remittance. Based on the “2020 Guidance for Foreign Exchange Business under the Current Account” released by SAFE in August, firms do not need any supportive documents or proof that it is under USD50,000. For remittances over USD50,000, firms need to submit supportive documents and taxation records. Under Chinese law, FIEs do not need pre-approval to open foreign exchange accounts and are allowed to retain income as foreign exchange or convert it into RMB without quota requirements. The remittance of profits and dividends by FIEs is not subject to time limitations, but FIEs need to submit a series of documents to designated banks for review and approval. The review period is not fixed and is frequently completed within one or two working days of the submission of complete documents. For remittance of interest and principal on private foreign debt, firms must submit an application, a foreign debt agreement, and the notice on repayment of the principal and interest. Banks will then check if the repayment volume is within the repayable principal. There are no specific rules on the remittance of royalties and management fees. Based on guidance for remittance of royalties and management fees, firms shall submit relevant contracts and invoice. In October 2020, SAFE cut the reserve requirement for foreign currency transactions from 20 percent to zero, reducing the cost of foreign currency transactions as well as easing Renminbi appreciation pressure.
Sovereign Wealth Funds
China officially has only one sovereign wealth fund (SWF), the China Investment Corporation (CIC), which was launched in 2007 to help diversify China’s foreign exchange reserves. CIC is ranked the second largest SWF by total assets by Sovereign Wealth Fund Institute (SWFI). With USD200 billion in initial registered capital, CIC manages over USD1.04 trillion in assets as of 2020 and invests on a 10-year time horizon. CIC has since evolved into three subsidiaries:
- CIC International was established in September 2011 with a mandate to invest in and manage overseas assets. It conducts public market equity and bond investments, hedge fund, real estate, private equity, and minority investments as a financial investor.
- CIC Capital was incorporated in January 2015 with a mandate to specialize in making direct investments to enhance CIC’s investments in long-term assets.
- Central Huijin makes equity investments in Chinese state-owned financial institutions.
China also operates other funds that function in part like sovereign wealth funds, including: China’s National Social Security Fund, with an estimated USD372 billion in assets; the China-Africa Development Fund (solely funded by the China Development Bank), with an estimated USD10 billion in assets; the SAFE Investment Company, with an estimated USD417.8 billion in assets; and China’s state-owned Silk Road Fund, established in December 2014 with USD40 billion in assets to foster investment in BRI partner countries. Chinese state-run funds do not report the percentage of their assets that are invested domestically. However, Chinese state-run funds follow the voluntary code of good practices known as the Santiago Principles and participate in the IMF-hosted International Working Group on SWFs. While CIC affirms that they do not have any formal government guidance to invest funds consistent with industrial policies or designated projects, CIC is still expected to pursue government objectives.