Shanghai is anything but shy about sharing its plans to become a top-tier international financial center (IFC) by 2020. That was made more than clear with the unveiling in May of the Bund Bull statue in the city’s former business and commercial district. The Shanghai Stock Exchange statue not only pays homage to its Wall Street iconic counterpart (both were designed by Italian-American Arturo Di Modica), but also is a reflection of the city’s desire to challenge the financial dominance of not only New York, and London as well. In a press release marking its unveiling, Zhou Wei, governor of the city’s Huangpu district, described the Bund Bull as “younger and more energetic” than its New York counterpart, “symbolizing the energy of Shanghai‘s economy.”
Last year, China’s State Council, the central government’s top decision-making body, formally approved Shanghai’s plans to become an IFC, directing the country’s ministries and regulators to open the way for the transformation. However, even though much about China’s economy can only be described with superlatives, central government support is not enough to secure Shanghai’s status as an IFC. The country’s financial infrastructure remains unfinished and the slow pace of regulatory reform — particularly for foreign-exchange convertibility and foreign ownership — are likely to hamper Shanghai’s grand ambition.
Shanghai has, nonetheless, made impressive progress. In equities, fixed-income instruments and commodities — the three onshore exchanges for which the city is known — Shanghai’s financial markets have grown in leaps and bounds. According to the World Federation of Exchanges, at the end of 2009 the Shanghai Stock Exchange was the world’s third-largest exchange by turnover (US$5.1 trillion) and the sixth largest by market capitalization (US$2.7 trillion).
As for the fixed-income market, the size of China’s renminbi (RMB) bond market as of March this year was US$2.65 trillion (with the government accounting for US$2.16 trillion of the total and corporate for the rest), or around 3% of global issuance, according to the Asian Development Bank’s online database of bond information. While dwarfed by U.S. dollar bonds (at 40%) and the yen (at 16%), its growth trajectory has been promising — in 1996, a total of US$62 billion of RMB bonds were outstanding, just 0.2% of global issuance.
Meanwhile, according to the Futures Industry Association, which monitors trade on international exchanges, the turnover value of China’s futures markets (including Shanghai, Dailan and Zhenzhou) in 2009 was more than RMB 100 trillion. In terms of volume of commodity futures traded (measured by contracts changing hands) domestically, China was the second largest market after the U.S., while Shanghai ranked 10th in terms of volume traded on global exchanges, Dalian 11th and Zhengzhou 12th. In 2000, Shanghai was ranked 29th in terms of volume, with 4.1 million contracts traded that year.
More of the same is expected, particularly if the country’s economy keeps growing as it has been. “No one could be accused of going too far out on a limb by predicting that in 10 years, China’s economy will be much different than it is today — that is, bigger and more powerful in the global scheme of things,” says Andrew Cainey, Shanghai-based managing director of greater China at consultants Booz & Company. “The growth is bound to benefit Shanghai in its effort to become an international financial center.”
A Question of Openness
While Shanghai might be big, can it be international? A new Goldman Sachs report titled, “Shanghai in 2020: Asia’s Financial Centre,” argues that although the city will gain in importance, it is more likely to “become a large domestic market rather than a broader regional market.”
But that’s not what city officials have in mind. They don’t want Shanghai to be like Tokyo or Seoul, both of which are impressive and vibrant cities at the hearts of their respective nations but aren’t — as Shanghai wants to be — at the absolute center of the global economy, whether in capital markets, trade or commerce.
For that to happen, Shanghai needs two things from the central government: The full convertibility of the RMB and the relaxation of controls allowing the free flow of currencies in and out of the country. Fang Xinghai, director general of the Shanghai Metropolitan Government’s Financial Services Office, noted in a recent television interview, “The currency will go global and foreigners will hold renminbi assets. But where will these assets be created? They will be created in this onshore financial center. So, first of all, Shanghai has to be open to let the assets go out and outside investment to come in. For that to happen, the capability of creating these assets has to be greatly expanded.”
The central government has said it wants to make the RMB fully convertible, although it has yet to provide a timeframe for that. In a positive step, however, the People’s Bank of China (PBOC), the central bank, announced in June that it will allow a strengthening of the RMB, which has been pegged to the dollar, which some economist had kept it artificially undervalued by as much as 40%.
For now, the government has allowed a limited amount of foreign investment in local markets through its Qualified Domestic Institutional Investor program and has permitted external flows through its Qualified Foreign Institutional Investor program. It also says it will allow foreign corporate entities to sell equities and bonds in Shanghai.
“Right now, we’re waiting for the first international share listings, which will be a milestone for Shanghai becoming an international financial center,” says Manop Sangiambut, head of RMB-denominated A-share research at brokerage house CLSA in Shanghai. “We just don’t know when that will happen. The government says that by the end of this year, there should be a few.” He predicts that many of China’s “red chips” — Hong Kong-listed and -incorporated mainland Chinese companies, such as China Mobile — will be interested in seeking listings in Shanghai, as will multinationals like Coca-Cola and HSBC.
Unlike in the past, government authorities will be encouraging such listings. Now that they have growing confidence in their mainland exchanges, including Shanghai’s, they’ll be encouraging the red chips — many of which launched initial public offerings in Hong Kong in the late 1990s — to seek dual listings on the mainland’s bourses. Still, there’s catching up to do. Goldman Sachs, bluntly, refers to China’s onshore capital markets as “relatively immature” and notes that Shanghai “has a number of important gaps compared with global and regional norms.”
CLSA’s Sangiambut adds that many products that are common in other financial centers are lacking or underdeveloped in Shanghai. For example, margin trading — buying stocks borrowed from a broker — was only introduced on a limited scale this year. Also, in spite of the growth in both value and volume, the depth of Shanghai’s market is limited, having the lowest level of foreign investment and the smallest free float of shares among regional peers.
“China doesn’t need another board, but they probably need to do more restructuring of the existing boards, including the B-shares [only open to foreign investors] in Shanghai and Shenzhen,” he says. “The next step will be more about deepening the market — in terms of shareholder reform and allowing access to more investing institutions — rather than broadening the market, adding things like a small and medium enterprise board or a growth enterprise market board.”
The key to broadening the market, he adds, will be the liberalization of the currency and foreign investment regime. “A-share reform is linked to the overall currency policy because you cannot have a truly open market until you have an open currency, and that isn’t happening in the foreseeable future.”
How quickly the issues can be resolved remains to be seen. “On the global position of the renminbi, the question is whether China’s government wants to make it a really international currency. My view is that the answer is negative,” said Andy Xie, director of London-based Rosetta Stone Advisors at Shanghai’s annual Lujiazui Forum in June.
Slow River Crossing
What do two other Asian financial centers — Hong Kong and Singapore — have that Shanghai doesn’t? A flexible regulatory regime. While these centers might not be able to match their rival’s size — according to the World Federation of Exchanges, average daily equity market turnover in 2009 in Shanghai was US$21 billion, in Hong Kong US$6 billion and in Singapore US$970 million, they are seen as fast moving, transparently regulated and investor friendly.
Helping Hong Kong and Singapore are their highly centralized regulatory overseers. Mainland China, in contrast, has a regulatory structure that often seems to encourage inertia. Bond issuance, for instance, falls under the authority of the PBOC, the China Securities Regulatory Commission, the National Development and Reform Commission, and in some cases, the China Banking Regulatory Commission, the State-owned Assets Supervision and Administration Commission or the China Insurance Regulatory Commission.
“There is difficulty with [regulatory] flexibility,” says Cainey of Booz. “China is such a bigger market [than Hong Kong and Singapore], but without currency reform, most of the RMB business is going to take place in Hong Kong.” The key to Shanghai’s transformation, he says, is how much business can actually be transacted there.
China’s deliberately slow and prudent approach to reform – encapsulated by Deng Xiaoping’s saying, “Crossing the river by feeling the stones” — could also work to the advantage of other regional financial centers with global aspirations. For instance, China has been slow in introducing stock index futures, which are a common hedging product in most markets. Shanghai’s CSI 300 equity index was launched in April this year after a three-year pilot program. The Singapore exchange, in contrast, has allowed trading of contracts on the FTSE/Xinhua A50 China index since 2000, allowing indirect access to the A-share market for offshore investors.
“China will open its financial markets gradually and with great care. Although this measured, conservative approach is understandable, finance thrives on innovation and therefore it would not surprise us if other regional centers advanced financial products that satisfied client demand but were not yet available in China’s domestic markets,” the Goldman Sachs report noted. “We would fully continue to expect financial centers, such as Hong Kong and Singapore, to press forward on financial innovation and product offerings as they compete for the mind and wallet share of the investment community.”
Along with relatively streamlined, nimble systems of governance, the two smaller centers have developed solid infrastructure — both hard (exchanges, telecommunications) and soft (courts, legal systems). In mainland China, meanwhile, all this is a work in progress and because of the country’s size and a complex multilevel system of governance, the process is no mean feat to orchestrate.
“There are clearly challenges. The difference between China, Singapore and Hong Kong is the sheer scale of what [China is] trying to regulate and manage,” says Cainey of Booz. “China still has a clear regulatory division across different sections of the financial market. The scale and roles of Beijing and Shanghai mean that getting coordination right is quite difficult.”
But these challenges are not insurmountable, reckons CLSA’s Sangiambut — if the central government has the will to act. “If the government wants to implement certain policies, they will get things done,” he says. “Opening up the financial sector in Shanghai is not about government agencies, but about getting the right mix of policies. You need a legal framework and a taxation framework to get professionals with financial experience to come to Shanghai.”
Indeed, while the liberalization of China’s foreign exchange regime is the linchpin for Shanghai’s transformation into an IFC, there’s another factor at play: Making Shanghai an attractive city for international financial experts to live and work. “Shanghai’s future depends on how much business you can do here and how well the city can attract talent,” asserts Cainey.
Like Sangiambut, he cites income tax as one impediment. Taxation on individual income can be up to 45% in Shanghai — in contrast, income tax in Hong Kong is capped at 15%. To address this, Shanghai officials floated the idea last year of tax breaks and incentives for financial professionals. However, because central government recently made the reduction income inequality a priority, the idea of providing tax breaks to wealthy bankers has, unsurprisingly, not gained much traction at the cabinet level.
The municipal government has had more success when it comes to improving other areas of the city’s attractiveness. In terms of infrastructure, for example, Shanghai has one of the world’s largest public transit networks, with 11 metro lines covering 420 kilometers. And while there have been concerns in the country’s major cities about a perilous real estate bubble, Shanghai has “managed pretty well over the last few years,” according to Goldman Sachs.
In some respects, Shanghai’s plans for 2020 are a bid to return to its f