OREANDA-NEWS.  September 24, 2014. The new Shanghai-Hong Kong Stock Connect scheme is a way into China’s equity market for global investors and a way for Chinese investors to go global. It allows investors in Hong Kong and mainland China to trade and settle shares listed on the other's stock markets.

There will be quotas on the north-south share dealing, but Stock Connect is open to more investors than existing ‘qualified-investor’ schemes as the quotas are applied to total market transactions, not allocated to selected institutions.

In the larger macroeconomic context, its launch suggests China’s twin processes of capital account liberalisation and internationalisation of the renminbi will continue to gain momentum.

But is this too soon? The experience of many countries in the region during the Asian financial crisis of 1997 highlighted the dangers of opening up to international capital before an economy is ready. China’s capital account was relatively closed during that period, which helped to insulate it from destabilising outflows.

It instead concentrated on trade globalisation, joining the World Trade Organization after implementing important reforms, such as in state-owned enterprises and housing. Now, opening its capital markets should act as a catalyst to drive domestic financial sector reforms.

China now has the requisite economic size and confidence in its currency, but its financial markets lack depth. However, that does not mean it should wait: opening the capital account can create a deeper domestic financial market and accelerate necessary financial reforms such as interest-rate liberalisation and greater flexibility for the currency.

The Stock Connect programme is another step along the way to opening China’s capital account. Indeed, one of its explicit aims is to help promote the internationalisation of the renminbi.

The first benefit from opening up is that it allows funds to flow to where they can be best utilised. Individuals will have more choice about where to put their savings while companies can tap into a global pool of funding for investment. Openness allows greater diversification of risk for domestic consumers, savers and corporations.

Opening up the capital account should also lead to greater competition in the financial sector, generating efficiency gains. By allowing more sophisticated global investors into domestic markets, China can bring in better investment experience, skills and technologies. Further, a larger pool of investors will increase liquidity and improve pricing of risk.

Are China’s financial system and its economy sufficiently robust to withstand the potential increased volatility that comes with a more open capital account? We think many of the prerequisites have already been met or are being met. Recent developments include a more flexible exchange rate, stable macroeconomic policies, low inflation, fiscal discipline, strong foreign reserves and low short-term debt.

Other reforms are still in the pipeline. We expect to see deposit-rate liberalisation within two years, a higher foreign ownership cap for banks and other financial institutions, plus the scrapping of restrictions on overseas direct investment. Expanding the corporate and local-government bond markets is also likely, as is agreeing further swap lines with foreign central banks to safeguard renminbi liquidity. We expect to see renminbi convertibility by 2017.

Financial reforms and capital account liberalisation are complementary and we believe they will be pursued simultaneously in China.