Following the UK referendum and the majority decision to support leaving the EU, there has been a flurry of activity by senior UK ministers seeking to sign up free, or perhaps freer, trade partners. Much excitement was generated in the UK press about apparent interest in fast tracking deals by Canada, Australia and Singapore. Unfortunately, these three countries import less than half the goods and services taken by Germany as an example. The UK has opened trade offices in the USA, our largest trading partner, although the writing on the wall, whoever wins the US presidential elections, is for a more protectionist USA over the next few years. However, a recent visit by the UK Chancellor of the Exchequer has raised hopes of a new dawn in Anglo-Sino relations on trade.
This latter option is worth considering in detail for how could the UK export more to China? And is this an opportunity for the financial sector, and, more specifically, the securities services business?
The reality is that China is already a sizeable trading partner. China is the UK’s sixth largest export market at £14 billion annual exports. There is substantial two way flows of capital and China is now the number one destination for capital investment in the world. China, including HK, was the fourth largest inbound investor to the UK, as measured by jobs created. In reality there are no great obstacles to greater exports or capital investment in China other than demand for goods and ability to get into the service economy in a complex market.
Much focus has been placed on the different investment strategies adopted. There has been liberalisation of portfolio investment into and from China, mainly through the easing of the qualified domestic and international investor rules as well as new infrastructures such as Stock Connect.
However, in line with many other countries, a genuine and deep rooted presence in the financial sector in China is hard to achieve. Banks have been permitted to take stakes in local banks up to a point. Joint ventures have taken place in various sectors with varying levels of success. But, taking the open UK market as a template, we have not seen anything like the successful acquisition and organic growth strategies of non-indigenous institutions into the UK such as Fidelity, Aegon or Axa and banks such as Santander
In order to appreciate the logic of the effective barriers to open markets in China, one needs to appreciate two fundamental needs of the local market. First the country has to manage the tension between the urban and the rural parts of the country with an estimated, mainly urban, middle class population growing to around 630 million by 2022. That is around 40% of the total population. However, this is an emerging market and within that population of 630 million, around half the households will be classified upper middle class by 2022, indicating households with $16-32,000 dollars of income per annum. This population will undoubtedly buy financial services, from insurance through to savings products. But will they do so off Western companies and what are the barriers?
Classically, there are multiple barriers for banking, including securities services. There are fundamental hurdles for foreign banks to overcome. First there is a protectionist approach to local banks and competition, beyond a point, is not enabled where there is a risk that those local banks could be denuded of their entire franchise. As an example of emasculation, we only have to look at the advent of US banks into the UK and the sequential exit of all bar HSBC from the domestic custody market. This will not happen in China and the hurdles will be multiple. There will be capital hurdles. Secondly, there will be limitations on branch creation, with the authorities and commercial ventures having disparate views of locations for new implantations with social need driving the authorities and commercial value the enterprises. Low levels of branch coverage will impact availability of local market liquidity. Finally there will be regulatory hurdles with different regulators allowing specific activities and operating at different speeds and according to diverse rules.
Traditionally securities services would take a footprint in a local domestic market by servicing their national champions as they expand into overseas markets. The insurance and fund management industry are global and well entrenched in Asia. The question is whether they can succeed in China. Irrespective of the low average salary for upper middle class families noted already, the sheer forecast size of the middle classes in China by 2022 means that if their savings ratio remains close on 30%, as distinct to 5-6% in the USA, annual savings will be some $ 600-700 billion per annum, or around that of the USA. Substantial sums will go into property and bank deposits but that leaves a meaningful amount for the fund management and insurance linked savings industry.
The EU has freedom of movement of capital as a core belief but we all know that there are real barriers to market entry, ranging from local regulation, local language, or access to distribution outlets and the need for local documentation and client portals. In China, in theory, language and regulation are not too great an issue as they are quite consistent across the country, but distribution and client access is a major challenge. Custodians, should one of them gain access to a national distribution network, would have a major opportunity to enable their clients’ funds to sell into the new domestic diaspora of middle class Chinese. But that is not the only hurdle for there would undoubtedly be specific regulatory needs that would not be compatible with the pan Asian experience or that from other locations.
The reality is that movement of goods is simple. Movement of services, especially those that carry systemic and retail wealth risk, are much more complex. The barriers to goods are tangible, with product content being definable. The barriers to services are subtle, with regulatory hurdles being aligned to important commercial ones.
I suspect it will take time for financial institutions with strong local presence and/or strong local ties to domestic institutions to gain a true foothold into China. Without that foothold, any political accord is theory and not the oft mooted bonanza for the bottom line.