A shot in the arm for financial market

The Shanghai-Hong Kong Stock Connect, which formally opened on Monday, is not only a giant step toward opening the Chinese mainland's capital account and financial market, but also a breakthrough in its efforts to open up further to the outside world.

Under such a program, investors in Shanghai and Hong Kong had been allowed to trade and settle shares listed on each other's markets through the exchange and clearing houses in their respective markets. For years the mainland has preferred direct investment to portfolio investment when it came to opening its capital account. Under such a policy, both inbound foreign direct investment and outbound direct investment by Chinese enterprises have enjoyed a high degree of liberalization.

But a rather strict regulatory regime was imposed on cross-border portfolio investment in both directions. Statistics show that the mainland's outbound direct investment reached $609.1 billion by the end of last year, more than twice its outbound portfolio investment of $258.5 billion. And its inbound direct investment reached $2.3475 trillion, in sharp contrast to $386.8 billion worth of portfolio investment.

When the mainland's economic aggregate was small, its financial market not fully developed, and the authorities lacked enough regulation capability, that practice did help maintain its macroeconomic stability.

But as it became the world's second-largest economy, China's financial market developed substantially. Its strengthened financial regulation capability also means that it is ready to lift the lid off some portfolio investment restrictions. And the Shanghai-Hong Kong Stock Connect is expected to help the marketization of the mainland's A-shares and facilitate further reforms in financial sector. The move is also expected to help raise the transparency of the mainland's cross-border capital flow and create better conditions for the regulation of such capital flows and the entire macro-economy.

Despite the long-standing strict capital account regulation, huge disguised capital outflows have been seen since the late 1980s, which means overseas investments by Chinese enterprises and citizens, including direct and securities investments, are far higher than the official figures. This trend gained pace in the mid-1990s. For example, the investment from the mainland in the mid-1990s was 0.6 percent of the entire stock market's trading investment made by outside investors in Hong Kong, but the percentage increased to 5.44 percent in 2006.

That mainland investors have invested heavily in overseas markets like the New York Stock Exchange and Nasdaq is no longer news. Since the conditions are ripe for the mainland to open its outbound securities investment, it makes complete sense to put such cross-border investments in the sunshine instead of letting them evolve into undercurrents that could hurt its macroeconomic stability.

The Shanghai-Hong Kong Stock Connect program will be of great help in optimizing the structure of the mainland's overseas assets, meeting the investment demands of some Chinese residents and offering them equal investment treatment. In the long run, the expanded outbound portfolio investment that can be expected, thanks to the Shanghai-Hong Kong program, and eased regulations will boost the central government's efforts to promote stable economic growth.

The move will also help mitigate the enormous pressure created by the mainland's fast-rising foreign exchange reserves and the yuan's appreciation. Since the demographic dividend China enjoyed is tapering off and its aging population increases, the country needs to garner some benefits from its ever-growing outbound investment as a way of minimizing the negative effects of the changed demographics on its economic and social development.

All moves and plans have their pros and cons, and the Shanghai-Hong Kong Stock Connect is no exception. So we should expect some stock market fluctuations after its implementation, as indicated by shares opening about 1 percent higher in both Shanghai and Hong Kong but quickly losing some gains and both markets falling into negative territory.

Foreign experiences indicate that the entry of high-grade foreign institutional investors usually adds to stock market fluctuations. Therefore, the mainland authorities should be on high alert against the possibility of more stock market fluctuations or a crisis sparked by increased investment outflows because of the repercussions caused in some emerging markets by the withdrawal of the US Federal Reserve's years-long quantitative easing policy.

The author is a researcher at the International Trade and Economic Cooperation Institute, affiliated to the Ministry of Commerce.