The Chinese economy is characterised by technology and creative ways of doing business – something that is evident in the real economy, all the way to its market infrastructure.
The development of a strong manufacturing sector and its ability to export its goods all over the world played an important role in China’s economic rise over the last four decades. But the idea that the world’s second largest economy remains dependent on low-cost production is woefully out of date following a decade of rising wages. On the contrary, the Chinese economy is shifting towards more innovative business models.
“One of the most astonishing economic developments over the last decade is the emergence of China as an innovation powerhouse,” said William Bratton, Head of Equity Research, Asia-Pacific at HSBC, who was speaking at HSBC Securities Services’ 2018 Leadership Forum.
From low tech to high tech
Perhaps the best way to measure this transition from low-tech to high-tech is via patents. At the end of the last century, China made a negligible contribution to the number of patent applications and grants. The country is now the leading force in patent applications – in 2016, China made 1.3 million applications, which is more than the US, Japan, South Korea, and the EU combined1.
The companies behind this flurry of patent applications, said Mr Bratton, are a demonstration of a highly innovative corporate sector. Furthermore, the growing size of China’s equity markets – both in terms of the number of listed companies and the overall market capitalisation – means that shares of many of these creative companies are available to investors.
“People who are bearish on China often take the view that the sectors associated with the old China dominates – areas such as resources and industrials. The idea is that innovative companies cannot access capital” said Mr Bratton. “But this ignores the fact that China has been rebalancing aggressively over the last few years, which is reflected in the public equity markets.”
A virtuous cycle
The combination of an innovative corporate sector and a dynamic equity market, creates a situation that is beneficial for both parties, said Mr Bratton. The capital markets not only represent an important source of funding for technology companies, they also provide a mechanism for early investors to monetise their investments. Other benefits include employee incentivisation via share options that reduce a small company’s cash flow requirements and increases the link between employee compensation and business performance.Stock markets benefit from technological developments in the form of lower trading costs and increased information symmetry. The way that people interact with listed companies is now seamless, transparent, with real-time pricing available for everyone from professional to individual investors.
Both of these trends are evident in China. Yet despite the impressive changes over the last few years, we might still be at the early stages of a more long-term change, said Mr Bratton. “China has only just started,” he said.
Banks remain the primary source of capital funding for corporates in China, and in the investment environment remains relatively informal and unstructured. China’s stock markets have a combined value that is equivalent to 71 per cent of the country’s, which is significantly smaller than US, where markets are worth 165 per cent of GDP2. There is clearly room for the equity market to grow in importance as a source of capital for Chinese companies, thus further supporting technological development.
Innovative market infrastructure
Innovation is not only evident in the new composition of the companies populating China’s equity markets, it is visible in the very structure of the market itself. The Connect programme is a unique series of initiatives that allows international investors to invest in China’s domestic markets via Hong Kong’s market infrastructure. Starting in 2014 with Shanghai-Hong Kong Stock Connect, the programme has expanded to cover the Shenzhen Stock Exchange, and most recently the local bond market.
“We have come a long way since we started four years ago,” said Mr Tae Yoo, Managing Director, Global Client Development, Market Development Division of Hong Kong Exchanges and Clearing Limited. He highlighted how the Connect Programme has continually added enhancements to ensure that it satisfies the needs of investors – these include the introduction of special segregated accounts, real-time delivery versus payments, and in August and September of 2017 the launch of a closing call auction in the Shanghai Stock Exchange.
In addition to introducing new features, the Connect programme needs to be robust enough to ensure that it can operate satisfactorily during periods of heavy trading. In 2018, the main challenge came from the inclusion of China A Shares into MSCI’s Emerging Markets Index, which resulted in heavy inflows towards Chinese stocks as passive investors rebalanced their portfolios.
There are a wide range of factors that an investor has to consider when using a scheme like Stock Connect for the first time. Can the system handle a large volume of trades? Can algorithmic trading strategies be implemented? Can brokers deliver on CNH (offshore traded renminbi) funding commitments, and can custodians really meet the deadline to confirm the trades?
“I am happy to report that all of the above was successfully implemented and completed with zero errors on both rebalancing days,” said Mr Yoo. And it is just the latest test of a programme that will develop in the future: “Connect will continue to evolve, providing new and better services to market participants and investors.”