More on Futures and China’s Capital Markets

At the Institutional Investor Third Annual China Investment Management Summit held recently in Beijing, a series of experts shared their outlooks for financial reforms in China and the development of the country’s financial futures markets.

One of the overall themes at the Summit was the benchmarking of China’s development against the experience of the United States. Dr. Yin Jianfeng, head of Financial Innovation Research at the China Academy of Social Sciences, broke down development of derivative products in the United States into three stages: the development of commodity derivatives; the development of simple financial derivatives; and finally in the 1990s, the development of highly complicated securities and derivatives. He explained that China’s development so far has been limited to commodity-based derivatives, and that while many years of study have gone into second and third-stage products, the China Securities Regulatory Commission (CSRC) has not yet approved any for implementation.

In terms of future development, Dr. Yin believes that China must significantly increase transparency in its financial markets, deregulate the market for simple derivative products, and maintain tight restrictions on complex financial derivatives until the simpler products have had a chance to develop.

Zheng Fang, founder of Hong Kong-based Keywise Capital Management, shared his views on the development of China’s financial markets from the perspective of a hedge fund manager. Keywise is focused on China, with 70% of its assets invested in securities tied there.

Zheng emphasized that Keywise uses derivatives primarily to mitigate risk, and much less so to enhance returns, and prefers structurally simple financial products. If an instrument is difficult to understand, he explained, fewer parties will trade the security, resulting in a low level of liquidity and inefficient pricing. For this reason, Zheng believes that China should focus on the development of simple financial derivatives that will attract large numbers of participants and promote strong and stable liquidity in China’s financial markets.

There was a consensus among Summit participants that Chinese regulators have been wary of taking deregulation too far and allowing it to occur too quickly, and that this is the key reason why the country’s capital markets have been slow to develop. A concern for the potential instability caused by bubbles and periodic, systematic meltdowns such as that which occurred last year in the United States and other global financial markets has taken precedence over the desire for faster development.

Zheng used the comparison of tai chi to boxing as a metaphor for the Chinese and U.S. approaches to the development of their respective financial markets. Chinese regulators, Zheng explained, prefer a “tai chi approach” to reform that is relatively slow, gradual and continuous, whereas regulators in the United States seem to prefer a faster paced, more aggressive reform process. But as Zheng pointed out, the power of tai chi comes from the moment at which all of one’s accumulated power and strength are released, a point he believes is not far off for China’s financial markets.

China’s economic development over the past 30 years has been largely driven by exports to Western economies, with the United States being the country’s largest customer. In the process, China has accumulated over $2 trillion of foreign currency reserves, much of which has been invested in U.S. treasury securities. Now that demand from consumers in the United States and other Western countries has fallen, there was general consensus that China must focus on the development of its own internal economy, including the development of its capital markets.

As far as opening China’s financial markets to the outside world, there was also a general consensus that China must first undergo internal deregulation and development before this can be done. By highlighting the instability that can result from vast inflows and outflows of outside capital into a country, the 1997 Asian Crisis caused China to focus on strengthening its domestic banking system before giving further thought to opening its financial markets to foreign investors. While providing a unique opportunity to learn from the experience of other countries, the recent global financial crisis has underscored for Chinese regulators the dangers of allowing the country’s capital markets to develop too quickly.

Expect more tai chi in China.

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