While China’s manufacturing sector booms and people sock away money in savings accounts, the country’s financial markets remain in their infancy, according to international finance experts who gathered at the recent 2008 Wharton China Business Conference.


That partly reflects the realities of economic development — the so-called “real economy” tends to develop in advance of capital markets. Once an economy takes off, as China’s has over the last several years, creative financiers start to figure out ways to fund investments, distribute gains and share risks. Yet the relative underdevelopment of China’s capital markets also reflects the biases of its powerful central government.


“Chinese regulators are comfortable with the real economy,” said Vincent Duhamel, managing director at Goldman Sachs Asia. “They are less experienced with financial markets.” Ideally the regulators should act only as referees, and allow the market to innovate, “but they are not comfortable letting the market do its own work.” Duhamel doesn’t see the “financial markets in China developing quickly. For now, there are too many regulatory restrictions, and liberalization is off the table because of what is happening in financial markets in the rest of the world. The subprime crisis has been a cold shower for them.”


Even a widely perceived Chinese strength — the country’s massive foreign currency reserves — reflects the underlying weakness of the financial markets, said Jennifer Amyx, a University of Pennsylvania political science professor. China lacks the financial infrastructure to internally deploy the huge sums of money that its exports are generating.


The Chinese government has therefore begun to invest part of these reserves abroad via the China Investment Corp., a sovereign wealth fund. While some U.S. commentators view the fund as a way for China to flex its new economic muscle and undercut the U.S., Amyx suggested that such notions ignore China’s economic realities and historic boom and bust cycles.


China isn’t the only country that has recently built up a trove of foreign exchange reserves, and it isn’t the only one that has created a sovereign wealth fund to handle them, she noted. A number of Middle Eastern oil exporters have them, too. “At $1.4 trillion, China’s foreign currency reserve is huge,” Amyx conceded, “but for many years, it was Japan that was buying U.S. Treasury bonds with its foreign exchange reserves.” At the time, some U.S. commentators fretted that Japan was, in effect, becoming the financial master of the United States. But those sorts of doomsday predictions never came to pass. Instead, in the 1990s, Japan’s economy entered a long slump.


Holding Investors Back


Another reason why fears of China’s fund may be exaggerated is that Chinese officials have not, so far, shown themselves to be the world’s most sophisticated or aggressive investors. They keep most of their country’s foreign exchange reserves stashed in stodgy, safe U.S. Treasuries. And while the China Investment Corp. has recently made riskier forays into the U.S. stock market, some of them haven’t fared well. The fund, for example, invested $3 billion last year in the initial public stock offering of the Blackstone Group, a U.S. private equity firm. Blackstone’s stock price has fallen by nearly half since then — a development that has made the fund even more cautious, Amyx said.


The lack of robust capital markets hasn’t yet hindered development of China’s economy, Duhamel noted. But the country is reaching a point where a shortage of financial innovation and investment alternatives will start to needlessly handcuff companies and the burgeoning investor class. As Chinese entrepreneurs rack up gains in their ventures, they are looking to diversify their personal investment holdings, and they are seeking a broader array of financial tools for their companies. So far, their government has circumscribed their options.


“A high proportion of China’s [domestic] assets — about 63% — are now in bank deposits,” Duhamel pointed out. “Equities are another 31% and the rest of the asset classes are underdeveloped.”


Bonds, for example, account for only about 6% of domestic assets. Here, too, overregulation has played a role, Duhamel said. Chinese bureaucrats have insisted on setting interest rates on individual bond issues. By doing that, they have thwarted the development of a bigger bond sector. “How can you have appropriate pricing of risk in that situation?” he asked. “Without freedom in setting rates, the market can’t create appropriate pricing.”


Other asset classes barely exist at all. “China has a futures exchange, but the depth and liquidity is insufficient,” he noted. “Whatever China doesn’t develop domestically, someone else will develop. You already have renminbi contracts trading on the Chicago Futures Exchange.”


Without a stronger, broader financial sector, Chinese companies can’t share and shift risk — a process that is necessary for companies to manage their finances effectively. Consider the insurance sector, Duhamel said. “Insurance companies in China have 40% to 50% of their assets in bank deposits, which doesn’t make sense.” The portfolio of a big American insurer would typically include a high proportion of stocks and bonds and a relatively modest allocation of cash deposited in banks. But Chinese regulators have elected to allow their banks to dominate the country’s financial landscape, leaving few alternative destinations for money.


At least one of those banks has implicitly acknowledged the shortcomings of its country’s capital markets. “When ICBC [the Industrial and Commercial Bank of China] went public in 2006, in the largest IPO ever, the bulk of the stock was distributed outside of China,” Duhamel pointed out. “Outside investors had the skills to assess the risk and the appetite for it. The Chinese retail market didn’t, and Chinese institutional investors couldn’t price it, either.” In addition, the bank’s managers wanted foreign institutional investors to hold their shares, so they could learn cutting-edge financial and management practices from them. They therefore first listed their company on the Hong Kong stock exchange, which is popular with Western investors. Only later did they sell stock in China’s A-share market.


Asking Difficult Questions


China could speed its financial maturation by giving foreign institutional investors more freedom to operate in the country, Duhamel said. So far, the government has carefully controlled the entry of foreign institutions like hedge funds, investment banks and insurance companies. Giving them freer rein would likely bring a host of benefits, including improvements in the governance and operations of all publicly listed Chinese firms. Because foreign investors are asking difficult questions, “the quality of Chinese companies is increasing and, in many cases, is now on par with Western companies,” Duhamel said.


Institutional investors, for example, typically demand high standards of accountancy from companies whose stock they hold, and they often put pressure on managers to streamline operations. That might curtail inefficient practices like the recent tendency of some Chinese firms to devote as much effort to investing in the stock market as they do to their core operations, Duhamel said. That sort of conduct probably wouldn’t be tolerated in a more developed market, where investors, for the most part, expect companies to either use their excess cash to make investments in their operations or return it to shareholders in the form of dividends and stock buybacks.


“A larger institutional investor base can increase the quality of the management of Chinese companies,” he noted. “They will demand less focus on trading in the market and more on the operational businesses.” On average, Chinese investors aren’t as sophisticated as Western ones. About 70% of the investors in China’s stock market are individuals with limited investment experience, and 30% are institutions, Duhamel said. In contrast, those numbers are roughly flipped in the United States, with 60% institutions and 40% individuals.


Duhamel warned that short-term macroeconomic forces may forestall any immediate financial market reform. For the moment, Chinese officials are grappling with two challenges. On the one hand, they are seeing inflation because of their economy’s fast growth and rising commodity prices throughout the world. The Industrial and Commercial Bank of China recently reported that prices rose 8.7% in February — the biggest inflation jump in more than a decade. Food prices, in particular, soared, shooting up more than 23%.


At the same time, Chinese manufacturers are facing the possibility that their biggest pool of customers, American consumers, will trim their spending. The U.S. economy seems to have slumped into a recession, and that could seriously dampen economic activity in China. “China is still export driven,” Duhamel said. “People talk about decoupling, and maybe the U.S. and Chinese economies are more decoupled than they were 15 years ago. But China is still dependent on U.S. consumers.”


The development of deeper Chinese capital markets could help Chinese companies better weather future slowdowns by giving them more ways to hedge their risks. “As China develops a strong domestic investment industry, it will be able to better allocate domestic capital, and it will decrease its cost of capital,” Duhamel added. “It will also be able to create alternative investments and reduce its reliance on foreign capital for investment.” Those steps should create a virtuous cycle: “China will eventually see the development of a full spectrum of financial products. That will increase the liquidity of markets and attract even more investors.”