China and Britain: A risky business?

It’s official: Britain is seeing other people. After years of a special relationship with the US, the two superpowers are no longer in an exclusive relationship.

Wooing China has been part of the UK’s strategy for some time. Right now, the UK is launching a feasibility study to link the Chinese stock market, which is largely closed to foreign investors, directly to the London stock market. And, the Chinese central bank is to issue short-term debt in London: the first time it’ll ever have done so anywhere outside of China.

Plans for linking the two markets, though, which were announced by the Chancellor George Osborne during his recent visit to China, may engender a source of volatility. It’ll be interesting to see how far this progresses over the next few months.

London dominates global foreign exchange trading but would find it hard to hold onto its position if the currency of the world’s second largest economy, and its biggest trader, wasn’t choosing the UK.

For China, its currency is on the road towards becoming convertible. As part of its RMB internationalisation strategy, China intends to increase the use of its currency overseas and eventually emerges a global reserve currency.

In the interim, China is choosing where to base its currency transactions and London has so far gained a solid foothold in the RMB business.

For the People’s Bank of China to issue short-term debt in RMB in the City of London in the near future is another step down this path. There isn’t a great amount of risk in a central bank issuing bills since they, after all, control the money supply. So far, the dramatic double digit falls in Chinese stocks haven’t been transmitted globally, except indirectly by dampening investor sentiment. That’s because few global investors are able to invest freely in the A-share market. It’s one of the reasons why volatility in China doesn’t get transmitted the same way as America’s.

But, if the Chinese market becomes linked to London, then London – and global markets – could be directly affected by the gyrations of Chinese stocks. The link between the stock markets of Hong Kong and Shanghai is one example, though the Hang Seng had been subject to shifting sentiment about China for a while due to the number of mainland companies listed there.
A price worth paying?

In some respects, London has also already borne more of the impact of the Chinese market crisis over the summer than others because it lists a number of commodity companies whose stocks have been dragged down by China.

Still, it’s a big step and one that the UK may well be keen on to cement a “special relationship” with the world’s second largest economy. It’s a strategy that makes sense over the longer term, since the special relationship with the US has been largely a fruitful one for Britain. But, in the short term, any direct links with China will entail a cost of greater volatility. The UK will need to decide if it’s a price worth paying.