China has begun taking long-awaited steps toward opening its market to foreign investors. Measures that open up the financial sector are expected by the end of next month. Meanwhile, China made it easier for foreign investors to trade its iron ore futures contract.
We argue that China, like many other countries, is developing a three-prong strategy for dealing with the Trump Administration. First, push back against tariffs, retaliating selectively. Second, challenge the US actions at the WTO. Third, some US demands that are perfectly consistent with President Xi’s agenda for China.
In March, China launched a yuan-denominated oil futures contract. We think that some observers put too much weight on the OPEC’s pricing of oil in dollars. It may have been more important in the early 1970s when the decision was made, but 45 years later, as the international financial order has evolved, the depth, breadth, and transparency of the US Treasury market is understood to be more significant than the vehicle currency and unit of account for oil. Early indications suggest that the yuan-denominated futures contract is primarily used by the domestic industry rather than speculators.
Rather than the internationalization of the yuan, or the demise of the dollar, as some suggested, the yuan-oil contract, the main beneficiary may be Iran if the US puts new sanctions on it. A yuan oil futures contract could help Iran minimize the impact of the sanctions.
At the end of last week, China made it easier for foreign investors to trade the Dalian iron ore futures contract. Previously, foreign investors could only access the futures contract by having a domestic account and this often required having a physical presence in China. This is no longer needed. There was an immediate response by some foreign accounts.
The main rival is an iron ore futures contract that trades in Singapore. Dalian volume is typically much higher than Singapore, but it is seen as a more retail market. Last year, trading volume of the Dalian futures contract was 20-times the global trade in iron ore and saw 20x the turnover of the Singapore-based contract. To put that in perspective, consider that in 2017, China imported a billion tons of iron ore and the turnover on the Dalian exchange was for nearly 33 bln tons.
The international miners and traders may still prefer the Singapore contract for the time being. Hong Kong Exchanges and Clearing launched a iron ore futures contract last November, but it has not found much traction. Liquidity in the Dalian contract is very concentrated, while the Singapore market is deeper. Foreign miners and producers may also be deterred by margin and currency issues in China.
Investors should be prepared for more market opening measures from China in the coming weeks, practically regardless of the evolution of trade talks with the US. By the end of next month, China will likely announce a dramatic easing of foreign ownership and other rules for banks, asset managers, securities firms, and life insurers. China has been intimating such reforms for years, and now, perhaps spurred by the prospects of a trade war, is expected to finally deliver.
The measures, a big bang of sorts, are expected to include lifting the foreign ownership limit of mutual funds and futures firm to 51% and then phasing out all limits within three years. Given the size of the Chinese market, a 3% stake by 2030 would be worth nearly $1 trillion. Foreign banks are expected to see their Chinese-based earnings rise sharply in the coming years. Foreign life insurers have done fairly well in China in recent years, according to reports. Their market share, measured by premiums, has risen for the past six consecutive years. Those already on the ground would seem to have an advantage.
The impact of some loss of market share by Chinese firms in these sectors may be mitigated by the continued growth of the pie itself. Also, the increased foreign participation may over time lead to better practices and could reform the capital allocation process in China and facilitate greater institutionalization of wealth management.
Meanwhile, investors are reflecting on last week’s US-China talks. It seems clear that there weren’t negotiations as much as a symbolic exchange of claims and counter-charges. We suspect the Financial Times had it right when they opined that the US demands were tantamount to a call for unilateral disarmament ahead of a potential trade war. The doubling of the USD initial demand that China reduces its bilateral trade surplus by $200 bln within two years shows aggressiveness.
The US wants China to refrain from any retaliation against US actions associated with intellectual property right violations. The US also demanded that China drop all of its WTO challenges of US practice. The US wants China to abandon the Made in China 2025 initiative which is both an import substitution development strategy as well as targeting what some see as the commanding heights of new industries and technology.
China is willing to buy more US goods and services. However, China demands that the US lift its export controls, especially for high tech. China also insists that it should be recognized as a market economy for WTO purposes. However, such a status makes it more difficult for countries to accuse China of some unfair trade practices, like dumping. China’s threat to consider the US as a non-market economy would likely free up a wider range of actions it could take should there be a significant escalation of trade tensions
We are suspicious of claims that US companies who service Chinese demand locally are sapping US exports. Certainly, it is possible, and there are plenty of anecdotes. However, the cost structure of US production costs associated with shipping and distribution of those goods in China may make them less competitive. Moreover, Chinese officials note that nearly half of its manufactured exports to the US are American brands. Ironically, and under-appreciated, the cheaper consumer goods are helping American households make ends meet as the labor force participation rate remains weak and wage growth uninspiring.