Index futures launch a milestone for China reforms

By Jason Subler and David Lin – Analysis

SHANGHAI (BestGrowthStock) – China’s launch of trading in stock index futures on Friday will mark a milestone in making its financial markets more professional and less speculative, even though they are likely to get off to a slow start.

By making it possible for investors to short the market or bet on a rise against the tide, futures, together with other reforms such as a pilot program on short selling of stocks, should ease the Chinese market’s notorious volatility.

If all goes smoothly, it could pave the way for the gradual introduction of a range of other derivatives and products, from options to global exchange-traded funds, that will be needed to realize the ruling Communist Party’s stated goal of building Shanghai into a global financial center by 2020.

“Short selling together with index futures are probably the two most important pieces in the China capital markets toolbox,” said Jerry Lou, China strategist with Morgan Stanley in Hong Kong. “These are two of the hardest roadblocks. I think the chances for it to work are fairly high.”

The stakes are high for the long-awaited introduction of futures trading, which was pushed back on account of the global financial crisis after years of planning.

It could serve as a watershed for accelerating reforms to liberalize the capital markets, gradually opening them up to greater inflows and outflows of investment and eventually culminating in making China’s yuan currency fully convertible.

If it goes wrong, as some experiments with reform have before, the whole liberalization project could be pushed back.

After bad experiences with the introduction of derivatives such as warrants, Beijing is taking few chances.

Marked by high margin requirements and other restrictions, few expect futures to make any major waves at first.

Roughly 6,000 futures trading accounts are expected to be opened by their launch, a tiny fraction of the 140 million investors in the Shanghai and Shenzhen stock exchanges, with only a handful of wealthy individuals passing eligibility standards.

Institutional investors are largely staying on the sidelines to start with as they await specific rules and foreign investors will not be able to participate at first.

Over time, however, futures should help bring greater diversity and professionalism to a market that has often been referred to as a casino — that is, rather than just adding another table at which to play, it could be a catalyst for a fundamental shift toward a more mature approach.

“The launch of index futures will be a new starting point for the deepening of China’s capital markets,” said Ba Shusong, a prominent economist at the cabinet’s Development Research Center.

That shift is expected to come in part by increasing the role of large institutions, as opposed to the current dominance by retail investors — who account for about 70 percent of stock market turnover and often end up following each other in one direction, leading to big market ups and downs.

NO MORE FOLLOWING THE PACK?

But it’s not just about mitigating the role of individual punters.

Many institutional investors themselves currently follow very similar investment strategies, in part because of a lack of hedging tools, which limits the scope for creating mutual funds or other products that veer away from either betting on a rising market or safely stowing money in cash, Ba said.

Index futures and the accompanying ability to short the market, or bet on falls, will open the way for institutions to design other products, such as capital-preservation funds.

Importantly, they should provide a channel to divert selling pressure when the market is falling, promoting long-term stability, said Gao Zijian, chief derivatives analyst with Orient Securities in Shanghai.

As investors increasingly seek opportunities for arbitrage between futures and the cash market, they will expand the volume of transactions in the spot market, improving liquidity, said Fang Shishen, formerly with Taiwan’s futures exchange and now an adviser at Orient Securities Futures.

A limited pilot program for margin trading and short selling was launched last month, and many analysts and investors hope that more innovations, like options, will follow in tandem with greater openness to the outside, eventually easing the tight restrictions on foreign participation in the markets.

Bringing China more fully into global markets would not only offer foreign investors more opportunities to benefit from its booming economy, on its way to surpassing Japan as the world’s second-largest, but also help ease some of the distortions caused by the current tight capital controls, analysts say.

SPECULATOR PERILS

But the launch of the index futures on the China Financial Futures Exchange on April 16 is not without its perils, especially worries about low liquidity and heavy speculation.

Mutual funds, brokerages and insurance companies, the very players who are expected to bring greater stability, have yet to see specific guidelines governing their participation.

Some observers also looked for cautionary tales from China’s stock warrants market, which often came to resemble a casino as low commissions and huge price swings drew speculators who often made wild bets on hopelessly out-of-the-money instruments.

“Six months from now, heaven knows? Index futures may have become just like warrants,” said Galaxy Securities analyst Ren Chengde.

But analysts said the tight initial restrictions showed the authorities’ determination to achieve a stable start.

“I think a successful launch would be mitigating risk, ensuring the system runs smoothly,” said Dean Owen, chief China representative for French futures brokerage Newedge Group.

“I would not expect huge volumes initially. That is not the priority. Once it is launched, people see it’s pretty smooth, and there’s no huge volatility…the number should grow exponentially.”

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(Additional reporting by Edmund Klamann and Samuel Shen; Editing by Alex Richardson)

Index futures launch a milestone for China reforms