China steps up focus on reforming cross-border investment schemes

A bid to open up China's capital account.

It has been noted that since the start of the year, there has been increasing investor interest over the key aspects of China’s financial reforms.

According to a research note from Credit Suisee, attention was focused intensely on the pace of internationalization of the CNY and the related freeing up of China’s capital account.

On this front, there are two key upcoming event risks, i.e. the IMF’s review of its Special Drawing Rights (SDR) basket and the MSCI’s market classification review.

One key deciding factor is the reform of two-way capital flows across China. As a result, to support its bid for a favorable outcome, Chinese authorities are busy reforming the whole family of cross-border investment schemes.

Here's more from Credit Suisse:

Two key event risks: The twin reviews of IMF-SDR and MSCI-A shares - The IMF is currently reviewing its SDR basket composition and it is expected that it will announce a formal decision sometime around October this year. Much hinges on whether the CNY is now regarded as a “Freely Usable Currency.”

In the IMF’s own words, this means a currency needs to be “widely used for international payments, investments and widely traded.” At the previous IMF SDR review five years ago, the CNY failed to gain admission because it was not deemed as a “Freely Usable Currency.”

Much has changed over the past five years. In particular, there is now a vibrant offshore CNH market, with a wide investible pool of assets ranging from offshore deposits to fixed income, backed by a liquid FX market.

Most recently, the IMF appears to have taken an important step forward. On 26 May, the IMF announced that it no longer deems the CNY as undervalued. This is an important change of assessment and is seen as an important step toward the integration of the CNY into the SDR basket.

However, the US Treasury swiftly responded by noting that “in the last US assessment, (CNY) remains significantly undervalued.” The US Treasury added that “it’s premature to say where IMF discussions on the (CNY) joining the SDR will go.”

We believe that a positive IMF assessment is an important stamp of approval for the Chinese authorities, that their efforts in reforming China’s currency regime and opening up the capital account is moving in the right direction and welcomed by the international financial community.

The other event risk is the MSCI’s Annual Market Classification review. Every year during June, a debate takes place on whether the MSCI will finally include China’s A shares into its index universe. The implications for the equity market and investment funds are significant given the potential large weightage that China’s A shares will likely command.

A detailed discussion on this topic is beyond the scope of this Investment Alert. Sufficient to say, there are important structural, tax, ownership issues that need to be addressed before the MSCI could add China’s A shares to its index universe. The MSCI is scheduled to announce the decision of its annual review on 9 June.

On this matter, FTSE Russell, a competing equity index provider appears to have stolen a march on MSCI. On 27 May, FTSE Russell announced that it will start two “transitional” emerging market related indices that include China A shares. These will be called the FTSE Emerging Market inclusion indices and will have an initial weightage of 5% for China A shares, potentially rising to 32% when China A shares become fully available to international investors.

China’s myriad of cross-border investment schemes - To better support its bid for a positive outcome in the twin reviews of IMF-SDR and MSCI-A shares, Chinese authorities have been actively reforming China’s cross-border investment schemes, so as to free up China’s capital account.

A free capital account is seen as an important prerequisite for two-way investment flows and a freely traded and usable CNY. In other words, Chinese authorities appear to be busy punching holes in China’s capital account wall, to make it more porous and efficient for two-way investment flows.

All the reforms on this front seemed to be directed at making the existing institutional-based cross-border investment schemes more efficient and introducing retail-based cross-border investment schemes for individual investors. Given below is a brief chronological overview of the various cross-border investment schemes and the various reforms conducted so far.