Shanghai needs a more resilient market to challenge London

Financial Times, MAY 7, 2018

China has big dreams for Shanghai’s financial sector. Last autumn’s Communist party Congress set the theme of “reform and opening-up” as a key strategic target over the coming decade. Chinese president Xi Jinping recently confirmed the government’s plans to pursue gradual liberalisation, starting with financial services.

The first step will be to ease ownership limits on foreign joint ventures in the financial sector. This reform will be applied first in Shanghai — which China hopes to make the next global financial centre. Not only does it have a century long history as China’s financial and commercial hub, it also has several advantages over other Chinese cities.

Shanghai has the greatest number of security firms, mutual funds, and futures companies, and the highest value-added in financial industries. The city has also enjoyed the swiftest pace of financial and economic reform. In August 2013, it became China’s first free-trade zone, eliminating financial requirements for setting up firms and permitting renminbi convertibility and unrestricted foreign currency exchange. The city’s long history of financial development and overseas commercial exchanges pre-dates the Communist regime. Nearly half of foreign banks’ total assets in China are currently held in Shanghai accounts; its stock market already facilitates trading in Hong Kong shares and is set to build a similar link with London.

Yet history shows the path to global pre-eminence will not be easy. In the 1980s, with the Japanese economy at its peak, its government sought to internationalise the yen and make Tokyo the rival of New York and London. Lack of overseas interest in the yen, resistance to deregulation and economic stagnation killed Tokyo’s ambitions.

Shanghai suffers similar weaknesses and more. Sceptics worry that an economic crash or similar “lost decade” could undermine the attractiveness of China’s financial assets. The renminbi is still heavily controlled by central government, vulnerable to a sudden monetary policy shift or foot-dragging on deregulation. And the US dollar’s enduring dominance makes renminbi-dominated assets less attractive for foreign investors — the same obstacle the yen has faced since the 1980s.

The Chinese government is moving in the right direction, seeking to increase overseas ownership of mainland financial products and to raise local households’ access to foreign assets. The plan for renminbi-denominated “depository receipts”, which allow domestic investors to buy shares in foreign-listed stocks through mainland stock exchanges, is positive. But it should go further, generating positive net capital inflows by allowing overseas institutional investors to put more money into its markets. Beijing remains fearful that liberalising rules for capital accounts too quickly could spark a financial crisis — so it is instead opting for piecemeal steps to open up financial services.

The rise and fall of past financial centres such as Venice, Amsterdam, and Paris, indicate that this cautious approach will create its own obstacles. Access to capital is insufficient to create a financial centre, let alone sustain a lasting one. Chinese markets and the economy more broadly need to prove they can survive major shocks.

Financial history suggests that such resilience requires a strong national economy, the rule of law and robust institutions that give investors confidence that their assets are secure. China has spent the past four decades creating the first condition. It still has work to do on the rest. In 2015, when the Chinese stock markets plunged, the government intervened with rescue plans. Now they must foster the conditions to allow investors to find their own way out of the next shock. That would provide real evidence that Shanghai is strong, healthy and ready to become the world’s next financial centre.

The writer is a research analyst at the Hoover Institution at Stanford University