China to Lure $3 Trillion as Foreigners Can't Resist, Citi Says

(Bloomberg) -- China has opened a path for a transformation of its financial markets that could see them match the U.S. in size and lure more than $3 trillion in capital from abroad by 2025, according to a study by Citigroup Inc.

While the country’s initial efforts to internationalize its currency hit a bump in 2015, policy makers have shifted tack to focus on developing domestic financial markets rather than opening up the capital account, Citigroup analysts led by Liu Li-Gang, chief China economist for the bank in Hong Kong, wrote in a note. Steps like the bond and stock "connects" with Hong Kong represent this new approach, they wrote.

"In years to come, 2017 could be viewed as a tipping point for global asset allocation," Liu and his colleagues wrote. "Removal of restrictions to entry, together with eventual inclusion of China in various global capital market indexes, will raise foreign ownership of Chinese assets, likely creating further momentum for market broadening and deepening."

Among the team’s projections:

• China’s nominal GDP, which is unadjusted for inflation, will reach $28 trillion by 2025 compared with $26 trillion for the U.S. based on anticipated growth rates and a gradual appreciation of the yuan to 5 per dollar from 6.8 now.
• Some $3.36 trillion in new capital will flow in from abroad, with $779 billion to the bond market, $200 billion into equities and $2.38 trillion to bank assets (which are typically loans).
• Based on their historical relationship with GDP, U.S. financial markets will total $137 trillion by 2025, and Citigroup assumes China’s would have about the same in yuan equivalent.

As it stands, China’s banking sector currently dominates its financial industry, with a two-thirds share, according to the economists. The bond market is forecast to almost triple in size to 188 trillion yuan ($38 trillion at the anticipated 2025 exchange rate), while equity markets will grow at a similar rate to 154 trillion yuan.

"If that is indeed reality in the not-so-distant future, institutional investors would no longer have the option of staying away from China’s markets if they wanted to achieve above-benchmark returns," Liu said. "Acceleration of reform of China’s capital markets in the next five to 10 years has the potential to reshape the allocation of global assets."

China is effectively rewriting the playbook for opening up its financial markets -- read about that here.

Past forecasts for game-changing developments from China have returned mixed results. In 2012 HSBC Holdings Plc analysts led by Qu Hongbin predicted a "Big Bang" of reforms from new leaders that would revolutionize the country’s financial system, including making the yuan fully convertible by 2017.

Citigroup analysts didn’t mention political risks, as President Xi Jinping prepares to oversee a once-in-five-years Communist Party leadership gathering later this year. Nor did they discuss whether the yuan would emerge as a rival to the dollar in the global financial system. Some foreign investors have expressed concern about pouring money into China given a panoply of political and regulatory risks that are hard to understand.

Overcoming Fears

The Citigroup team is betting that in time international investors will overcome their concerns.

"Initially, they would likely be cautious given structural imbalances, regulatory risks, capital controls and a still opaque tax regime," the group wrote. "But we see those concerns as being gradually eclipsed as conviction solidifies about China’s reform agenda and given the sheer size of the market opportunity."

Citigroup also saw China’s new approach toward keeping controls on the capital account in place while foreign investors are gradually welcomed to participate in domestic markets as one that would avoid the kind of instability seen during the 1990s Asian financial crisis.

"This sequencing policy should help China avoid unnecessary mistakes and mean it is spared the financial crises that have blighted other economies," they wrote.

To contact the reporter on this story: Eric Lam in Hong Kong at elam87@bloomberg.net.

To contact the editors responsible for this story: Christopher Anstey at canstey@bloomberg.net, Colin Simpson