Undeveloped economies typically rely on banks for finance. Makes sense: It takes decades to develop reliable securities markets and the legal, regulatory and accounting infrastructure to support them.
A capital markets tradition in the United States and Britain has produced efficient and sophisticated markets well ahead of those in continental Europe, where only in recent decades have economies turned from a long tradition of bank finance.
Capital markets in Europe have grown more robust only with prodding from US and UK institutional investors and investment banks.
So it’s not surprising that China, too, now faces a turning point in the evolution of its financial systemOpens a new window with a shift from bank lending to capital markets. What makes this historic transition crucial for the rest of the world is the size of the Chinese economy, its trading weight, and the closed nature of its society.
Banks in trouble
A brewing banking crisis is spurring the transition.
Stocks and bonds account for only 10% of corporate finance, the rest coming from banks and shadow banking entities such as so-called wealth management products. But now, years of abuse in bank lending is catching up as the economic growth that floated all these boats is in decline.
Companies funded long-term projects with short-term funds while banks channeled businesses to those with connections, including their own shareholders, hiding debt through creative balance sheet accounting.
In May, the government seized Baoshang BankOpens a new window in Inner Mongolia, its first bank rescue in 20 years. Since then, half a dozen other regional lenders have received government aid.
The government is pushing consolidation in the sector, merging institutions and restructuring them.
Channeling funds
At the same time, it’s promoting issue of shares and bonds. The government is anxious for savers to put their money into long-term projects where value can grow over time rather than trying to fund them with short-term loans financed by bank deposits.
That translates into development of the annuities sector and a bigger role for mutual funds and retirement plans. Typical of these measures was the launch in July of a Nasdaq-like tech stock marketOpens a new window to enable giant businesses such as Tencent and Alibaba to tap into domestic savings.
Ironically, this pivot threatens to exacerbate the problems in banking, weakening a shaky structure as money flows out of the banking system and into capital markets.
While enticing domestic savings into securities is the government’s main objective, Beijing faces a challenge in opening up these embryonic markets to foreigners — a process that counters the government’s knee-jerk instinct to control and limit foreign access to the country’s financial system.
Increasing foreign investment
Indices such as MSCI benchmarks are the spearhead for foreign investment in China, enabling fund investors to access a diversified basket of A-shares. MSCI is increasing the weightingOpens a new window of Chinese large-cap stocks in its Emerging Markets Index and adding mid-caps to bring their total weight in the index to 3.36% in May, up from 0.71% in October 2018.
Progress has been slow, however, with foreign ownership of equities at just 2%Opens a new window , although foreign bond holdings have risen to 8% of the total over the past five years.
Analysts project inflows in excess of $100 billion annually, in large part due to the increased index weightings, which should bring foreign ownership of Chinese equities to around 10% of total market capitalisation over the next decade.
Since April, the Bloomberg Barclays Global Aggregate Index has been adding Chinese government and development bank bonds with the goal of reaching a weighting of about 6%, which could spur $150 billion of fresh inflows into the bond market by November.
The main caveat both at home and abroad is the uncertain course of the economy. Annual growth has already slowed to an official  level of 6% from double digits just a few years ago. Any further uncertainty about the stability of the economy could make investors skittish.