China’s newly reclaimed role as the “Middle Kingdom,” showcased at a recent gathering of world leaders in Beijing to celebrate China’s “New Silk Road,” should have vanquished any lingering doubts about China’s commitment to weaving its markets and manufacturers more closely into the global economy. “We need to seek win-win results through greater openness and cooperation,” President Xi Jinping proclaimed at the Silk Road event. Xinhua, the state-run news agency, declared Xi an “ardent champion of globalization” and the “architect” of China’s plan to connect countries with a 21st century version of the ancient Silk Road.

But the pace of reforms needed in China to push that process forward has been slowing and is unlikely to regain momentum until at least after a key Communist Party Congress in the autumn, or maybe after President Xi Jinping’s next administration presumably takes office in March 2018. And no matter how much Xi strives to claim the lead in open trade and battling protectionism, Beijing’s commitment to globalization and integration of its markets and financial systems will come on its own terms, at its own pace.

However, China’s influence on world markets far outweighs the degree of integration of its own banks and financial markets with the rest of the world. While the country has only gradually eased controls on its capital account and foreign exchange markets, illicit flows of capital are playing an outsized role in overseas real estate and stock markets, and investments by its big corporations are altering the world industrial landscape. State enterprises and private companies, meanwhile, are investing aggressively in strategic areas such as food, energy, robotics and infrastructure.

Caution prevails ahead of the party congress. While Xi needs the economy to remain on an even keel, expanding at a fast enough pace to avoid major layoffs, his priorities lie elsewhere, says Pieter Bottelier, a visiting scholar of China Studies at Johns Hopkins School of Advanced International Studies in Washington. The lingering effects of the global financial crisis is a key concern. “The international system is so unstable and they have become increasingly reluctant to join the system. Joining the international system may increase instability and volatility,” he says.

Chinese M&A Slows

China’s robust mergers and acquisitions pace is driven not so much by a desire to snap up lucrative assets or the opening of more markets as it is about upgrading Chinese industries with improved technology. The aim is “increasing Chinese content of Chinese industry up to 70% by 2025,” says Chi Lo, a senior economist for Greater China at BNP Paribas Investment Partners in Hong Kong. “It’s a mid-term program to upgrade the Chinese economy so that Chinese can compete with the world’s advanced economies.”

“China needs to do a lot of work. For example, its capital markets do not work well.” –Franklin Allen

China’s central role as a world factory floor is not matched by advances in its financial sector. Despite their huge size, China’s banks lack a major global footprint. Its capital markets also lag behind, even though China’s two stock exchanges in the Mainland — in Shanghai and Shenzhen — when combined are the world’s second largest by market capitalization, says Franklin Allen, an emeritus professor of finance at Wharton and a professor of finance and economics at the Imperial College London.

“China needs to do a lot of work. For example, its capital markets do not work well. The bond market is improving but the stock markets are still a problem and are not representative of the Chinese economy,” Allen says. “They need to reform IPOs, delisting procedures and corporate governance. There is a lot to be done there.” The Shanghai and Shenzhen stock exchanges are tightly controlled and limit participation by foreign investors.

Also slowing down needed reforms is the impact of capital outflows on the value of the yuan, or renminbi. A devaluation in August 2015 roiled world financial markets and Beijing saw the pace of overseas acquisitions falter in 2016 as China slowed capital outflows to prop up the yuan. China’s foreign reserves have fallen by about $1 trillion since June 2014 as it bought its own currency to defend it. “Some of the reforms were affected by that, and they cannot move as fast with them anymore as they originally wanted,” says Rajiv Biswas, Asia-Pacific chief economist at IHS Markit in Singapore.

China’s restrictions on capital outflows mean that individuals, for example, cannot take out more than $50,000 annually, and only for non-investment purposes like education, medical care and tourism. In reality, much more escapes the country both through individual and corporate investments. Since capital outflow pressures remain, any let up in the controls would just start them back up, says Biswas. “They want to stabilize the situation but they are nervous about what could potentially happen.” The very large size of recent mergers and acquisitions, such as Qingdao Haier’s $5.6 billion purchase of GE’s appliance business, means China will remain cautious about allowing reserves to fall any further, he says.

Developing more comprehensive, well-functioning capital markets with a wider choice of financial products would help counter concerns about capital outflows and currency volatility, according to a recent report by the Asian Securities Industry and Financial Markets Association. Beijing has to choose between financial stability and the freedom and flexibility of a global currency demanded by international investors, the report noted. The lack of investment and financing options puts too much access to credit in the banking sector and limits China’s capacity to provide investment returns needed to support economic growth and provide adequate social welfare. Ultimately, Beijing needs to make the yuan fully convertible if it wants it to gain recognition as a truly global currency like the euro, yen or U.S. dollar, the report said.

“If people have confidence in yuan, then that will give them more capacity to use the yuan to do a lot of M&A deals, trade and investment without having to use foreign exchange reserves,” Biswas says. Once China becomes the world’s largest economy, expected to happen in the coming decade, it will need to have a currency that is on that level to match its stature in global affairs.

Slow-phased Reforms

For now, though, China is moving slowly on reforms to avoid putting further pressure on its foreign reserves, says Louis Kuijs, head of Asia Economics at Oxford Economics in Hong Kong. China still has the world’s largest foreign reserves, at $3.009 trillion in March, up from $2.998 trillion in January. But that is down from a peak of $3.99 trillion in June 2014.

The 2008 global financial crisis and the wild gyrations that followed China’s last round of currency liberalization in 2015 have convinced Beijing that pushing ahead with internationalizing the yuan at this stage would carry more risks than benefits, says BNP Paribas’s Lo, who has authored several books on China.

“If people have confidence in yuan, then that will give them more capacity to use the yuan to do a lot of M&A deals, trade and investment.” –Rajiv Biswas

To gain the Chinese currency’s acceptance for use in the International Monetary Fund’s Special Drawing Rights basket of international reserves, regulators removed a cap on deposit interest rates in July 2015 and a month later shifted away from a de facto peg of the yuan to the U.S. dollar, allowing more flexibility. China also signed swap lines with more than 30 central banks. Lo notes that a decision by Argentina in late December 2015 to use its swap line, selling $3 billion worth of yuan for U.S. dollars to replenish its reserves, rattled Beijing. Short-selling by foreign traders has also added to downward pressure on the yuan.

Small wonder that China slammed on the brakes. Recently, “we have not seen any opening up of new sectors for foreign investors,” Lo says. “China wants to open up more sectors to foreign investors, but that is a long-term thing,” he said. The service sector, especially, remains largely closed especially for private commercial banks and other financial institutions.

China has managed to keep its financial markets largely insulated from potential outside shocks thanks to the rapid accumulation of wealth that has fueled strong investment by Chinese individuals, companies and pension funds. “It is basically a domestic market and that is what the Chinese government wants. They do not want a huge foreign ownership because it could be destabilizing — you get hot money flowing in and out,” Biswas said.

But China’s economic woes continue. Earlier this year, Moody’s downgraded the country’s credit ratings for the first time since 1989 on the expectation that China’s financial strength will erode over the coming years, with debt continuing to rise as potential growth slows. It downgraded China’s long-term local currency and foreign currency issuer ratings to A1 (medium to high quality) from Aa3 (low risk).

“While ongoing progress on reform is likely to transform the economy and financial system over time, it is not likely to prevent a further material rise in economy-wide debt, and the consequent increase in the contingent liability for the government,” according to Moody’s. It expects the government’s direct debt burden to rise gradually toward 40% of GDP by 2018 and closer to 45% within a decade. A report by Capital Economics’ chief Asia economist, Mark Williams, says this: “We agree fully with Moody’s view that reform over the past year has been slow. As a result, further slowdown in growth now seems increasingly likely.”

Separately, there have been incremental changes in China’s market-opening efforts. Earlier this year, China opened its foreign exchange market to allow hedging by private foreign investors, up to the amount of funds they are managing inside China. It also is allowing foreign investors to invest in the onshore bond market, a small step toward opening the country’s capital account fully to foreign direct investment and portfolio flows.

Recently, the Asset Management Association of China gave a green light to Fidelity International to launch a fund in China for Chinese institutional investors and wealthy individuals. It was the first time a foreign fund manager was allowed entry into the potentially lucrative private investment sector. The Fidelity China Bond No. 1 Private Fund will invest in China’s $9.4 trillion bond market. Fidelity, which split from U.S. mutual fund giant Fidelity Investments decades ago, doesn’t have any quotas as part of China’s Qualified Domestic Institutional Investor program that lets Chinese institutional investors invest overseas. But it is teaming up with Chinese banks that have quotas under the program.

Onshore Investment Moves Ahead

Progress on opening to foreign government institutions has come a bit faster. In 2016, Beijing opened China’s onshore stock, bond and foreign exchange markets to official foreign financial institutions such as central banks and sovereign wealth funds. “If you speak with any central bank, they now face no restrictions on investing in China and getting their capital back,” Lo says. “It is basically capital account convertibility for official foreign institutions.”

“China wants to open up more sectors to foreign investors, but that is a long-term thing.” –Chi Lo

Although China’s regulators are wary of external shocks that open capital markets can bring to exchange rates, share prices and the financial system, they understand such reforms are needed. But proceeding cautiously is key. “If they go too fast … the changes could crash its financial system before they see the benefit,” Lo says. “If you are talking about full capital account opening, it will be a very long-term process. I see it taking at least 10 years to see China open its capital account completely like Japan.”

Keeping China’s financial markets relatively closed off from the rest of the world will not, as some like Martin Wolf of the Financial Times contend, prevent it from affecting global financial systems. Lo concurs: “We already feel Chinese influence with a relatively closed Chinese financial market. I do not think that keeping the Chinese market closed will help shield the world from Chinese influence. The Chinese economic system is so integrated in the global system in terms of supply chain that whatever happens in China, it would send shock waves to the world economically.”

Some experts, like Bottelier, doubt China will ever truly adopt a free-floating exchange rate. He sees policy shifting more to the political left, which is a party-dominated form of state capitalism that puts the party’s interests ahead of a convergence toward global norms. How soon will China integrate its financial markets globally? “Under the current political system, not ever,” he says. “Overall, I fear that the momentum of financial sector liberalization is essentially dead.”

But many other analysts expect reforms to accelerate once Xi has further consolidated his power after the party congress, which occurs once every five years, in the autumn. While the government will find it more difficult to control prices, closer integration with world markets would help bring more discipline to China’s somewhat disorderly bourses, which some Chinese experts have likened to “casinos.” Adds Allen: “It’s a political issue. Do they want companies to pursue shareholders rights? … How much do they want to control capital flows because of the issue of people taking money out of China? These are political issues. It may become easier to do financial reforms after the party congress.”

The underlying agenda is liberalizing China’s markets, Biswas says. But the experience of the past few years has left China’s leaders understandably cautious. “They want to liberalize the domestic capital market and to create more efficient markets and improve investor product ranges,” he explains. “It will be very slow reforms because they do not want to destabilize markets with sudden reforms and create big volatility in capital flows.”