Beijing has seen this threat coming and in 2015 launched its own alternative international bank messaging system...
There is an earlier precedent: in 2014, when Moscow was concerned about the potential escalation in sanctions, the Bank of Russia launched its own version of SWIFT, called SPFS3. In 2019, it had reached a 15% share4 of domestic transactions. Clearly Beijing would appear to have a higher likelihood of successful adoption abroad of its CIPS than of Moscow and its SFPs.
Hong Kong – the US Dollar link is in play
Hong Kong has gone from being apparently ‘untouchable’ to being treated as any other Chinese city in the space of a few short years. The most compelling evidence of its new status was in the introduction of the mainland Chinese national security law in May 2020. This is a law that provides the government with sweeping powers to arrest those suspected of subversion, secession and terrorism. There has been a sharp rebuke from most western countries and notably the US Congress and Senate are ratcheting up the pressure with new acts in the pipeline, such as the Hong Kong Be Water Act5 of October 2019, which would require the president to impose Global Magnitsky sanctions (visa ban and financial sanctions) on Chinese or Hong Kong government officials who have “knowingly suppressed or facilitated the suppression of the freedoms of speech, association, assembly, procession, or demonstration of the people of Hong Kong.”
Large Chinese banks have so far been cautious on the US sanctions imposed on Hong Kong persons, requiring a higher compliance threshold on account opening in Hong Kong, which is a radical departure from past practice. The fact is, these large banks require continued access to US dollar funding and there is a precedent in 2012, when Kunlun bank, a small Chinese entity, was cut off from US dollar funding6 because of a breach of Iran sanctions.
There is no doubt the golden age for Hong Kong has passed. It is no longer the only economic gateway to China, benefitting from British law and relative transparency of governance. The city’s economic heft is now 2.7%7 of Chinese GDP, with a corresponding fall in economic importance for Beijing’s agenda. But Hong Kong still benefits, for now, from its direct linkage into the US dollar interbank market. Could that be severed? It would be a big blow, but there would be a ‘hit’ to US interests, too. So perhaps this goes into the category of potent threats rather than policy options for the foreseeable future.
Portfolio flows are a favourite benchmark used to ascertain the relative attractiveness of a country’s capital markets, at a particular point in time. In the short-term, they are useful indicators of the direction of travel of capital flows but, as any finance minister knows, portfolio investors are notoriously disloyal and will flip from buyers to sellers in a heartbeat, if that appears to be in their interests.
Equity investors, even when boosted by counting the enormous volumes moved by exchange traded funds (ETFs), are overshadowed by fixed interest investors in terms of market value of portfolio investments. According to Fitch Ratings, foreign institutional investors held CNY2.8 trillion8 ($409 billion) in onshore local currency Chinese bonds at the end of August 2020.
Data from the International Institute for Finance (IIF), focused on portfolio positioning of fixed interest investors in emerging markets, calculates that on an aggregate basis, the current positioning is in the order of 30%9, as shown in the chart below, compared with a benchmark weighting of 9%.
According to data from clearing houses Central China Depository & Clearing Co (CCDC) and Shanghai Clearing House, foreign (offshore) investor holdings of Chinese interbank market bonds are now at RMB3.25 trillion10, which is a +48.8% increase during 2020. Foreign holdings of Chinese government bonds (CGBs) reached a record RMB1.88trillion11 at the end of December 2020, implying a +44% increase over the year.
Blocking access to US capital markets
The Public Company Accounting Oversight Board (PCAOB) has been unsuccessful at obtaining agreement with the Chinese authorities to secure access to the audit records of Chinese companies and in the current climate, the nuclear option has been presented: the Securities and Exchange Commission (SEC) will prohibit trading in any shares where the company’s auditor has not faced a PCAOB inspection for three consecutive years. This exercise would require the companies to disclose whether they are owned or controlled by a governmental entity. The Senate has presented Congress legislation to write this into law, with bipartisan support. Chinese law sets limits to disclosure and currently prohibits Chinese accounting firms (including local affiliates of international firms) from sharing audit documentation on companies, on the grounds of national security12.
Effectively this places all Chinese companies with American Depositary Receipts (ADRs) on notice, with the real prospect of China joining the US Department of the Treasury’s list of countries subject to broad economic sanctions (such as Iran and North Korea).This would clearly limit the investable universe for US-based asset owners, but it could potentially be made a condition of trade deals or defence pacts, that the third country signing with the US must disavow relations with China. This is perhaps the most far-reaching impact for investors in the short term, although the investment world will quickly identify parallel mechanisms to get around the problem.
At the time of writing, the New York Stock Exchange is moving to delist three large Chinese telecommunications companies, following guidance from the US Treasury after an executive order from President Trump13. Index provider MSCI14 removed 14 Chinese stocks from its Global Investable Market and Indices (GIMI). FTSE Russell followed suit15. The best known (and most widely held) names in the frame now are Tencent and Alibaba. They are not in the list of 14 and have not been removed from China indices, but there is a clear implication, even after the change of administration in the White House, that they could be specifically targeted in future. For investors in any company added to the exclusion list, it would be prudent to assume that they remain in place for some time. The onshore China ‘A’ share market, where domestic Chinese investors can invest, should be the main beneficiary. With Chinese demographics ageing and a continued broadening of the middle class, growing pools of domestic savings will increasingly choose to invest in equities. The prospect of this growing investor-base will trigger ‘onshoring’ by many Chinese companies currently quoted overseas.
Belt and Road
The Belt and Road Initiative (BRI) is a projection of soft and hard power, now useful as a tool to accelerate the recruitment of beneficiary countries to the Chinese side. That means cementing access to those markets, integrating Chinese companies into those economies, establishing secure long-term supplies of raw materials, resources and agricultural products, while taking steps to encourage adoption of Chinese technical and technological standards. Given the paucity of alternatives for many of these countries and the promise of reflected glory for governments seen to be bringing in investments, it would be logical to assume the majority accept and become integrated into Beijing’s sphere of influence. There are currently 12616 countries on that list, but the most compelling example is Pakistan, a strategically located nuclear power.
Any rupture of the financial linkages between China and the West would have a devastating impact on global trade...
Source: CPEC official site, Government of Pakistan
The CPEC18 commitment covers energy, transport & logistics, health, education and water supply. So far, 5,320 MW of generating capacity (31% of target) and 2,548 km of highways (36% of target) have been delivered at a cost of $10.8 billion. There are a myriad of projects including 4,122 km of railways and a series of industrial zones on the plans which, if delivered, will transform the country by 2030.
But one of the more interesting subplots of CPEC is an attempt to increase the use of the renminbi (RMB) as an international currency. This is a push from Islamabad, not Beijing – it stems from IMF constraints, dwindling US dollar reserves and persistent current account deficits. China has recently doubled its RMB Currency Swap Agreement with Pakistan to 40 billion yuan. It has been reported that this arrangement has been replicated for 19 other countries16 on the BRI. It is not clear at this point how successful this effort might be, as most private businesses prefer dollars or euros and there is a limit to the amount of goods that countries like Pakistan can buy from China.
Pakistan and the CPEC have proved to be the shop window used by Beijing to demonstrate what it can do to help countries that sign up to the Belt & Road Initiative.
The financial sector is as important as the energy sector in terms of contribution to a country’s process of industrialisation. So, it could be targeted in a scenario of continued escalation of measures and countermeasures. The headlines, however, have predominantly been about technology, trade and deficits and very rarely about structural financial sector connections between China and the West. The assumption seems to be that there is no appetite to trigger a definitive break because there would be a prohibitive cost to everyone. In a (still) interconnected world, any rupture of the financial linkages between China and the West would have a devastating impact on global trade and by extension, on the global economy.
The next decade will likely see increasing efforts to disassociate the two largest economies in the world. Investors are well aware of the mounting pressure on governments to take sides. In the developing countries, China’s offer of its affordable Coronavirus vaccine and the infrastructure buildout of the BRI has already found a warm welcome. The only issues that could potentially derail this development are a sudden and commensurate generosity of finance from the US, evidence of poor-quality execution in the BRI, or a particularly shocking political misstep by Beijing. All seem unlikely at this point, thus underlining that should the US-China decoupling continue, there are many countries already committed to the Chinese sphere of influence and relatively few prepared to cut ties altogether. For all of them, the prospect of cutting financial linkages with Beijing is an irreversible step too far.
Capital flows are dependent on credible banks and exchanges as well as secure and dependable communications services like SWIFT. China has Hong Kong, Shanghai and arguably Singapore within its orbit. Its telecommunications and technology backbone in the Belt and Road countries also provide guarantees of safe capital flows. Money flows like water, searching for the route of least resistance; it is no easier a task to block the free movement of capital than it is to block the flows of ideas and knowledge.
In the West, the demographic clock is inexorably ticking; the prevalence of underfunded pension liabilities require increasingly higher returns – with China and Asia promising consistently higher growth over the next 20 years, it becomes even tougher to impose a barrier to investment in this area of the world.
As a result, the long-standing financial sector linkages should continue relatively unmolested, because of their importance in the stability of global trade and economic growth. Perhaps this sector is one where the influence is maximised by the threat of rupture, not by the act of cutting these links. It will always remain near the top of the list whenever any US government wants to increase its negotiating leverage.
1Source: SWIFT Traffic Highlights 2019
2Source: CIPS Participants Announcement No.60
3Source: Bank Rossiya, Financial Messaging System
4Source: TASS news agency, May 28, 2020
5Source: Hong Kong: Recent Developments and U.S. Relations, Congressional Research Service, 6 January 2020
6Source: US Department of the Treasury press release, July 31, 2012 Treasury Sanctions Kunlun Bank in China and Elaf Bank in Iraq for Business with Designated Iranian Banks
7Source: World Bank data, Statista, 19 September 2019
8Source: Fitch Ratings report ‘China Corporate Funding Liquidity and Defaults’ September 30, 2020
9Source: IIF December 22, 2020
10Source: Nasdaq January 7
12Source: China’s 2017 National Intelligence Law holds that the government is the ultimate arbiter of disclosure and states that citizens and companies have a duty to cooperate with state intelligence and security agencies.
13Source: Executive Order 13971-Addressing the Threat Posed by Applications and Other Software Developed or Controlled by Chinese Companies
14Source: MSCI Index consultations, January 8, 2021 Index consultations - MSCI
16Source: Xinhua 2019-09-14
17Source CPEC official site, Government of Pakistan
18Source for map: CPEC Factbook 2019 – Government of Pakistan Ministry of Planning Development & Reform p11
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