China’s growing global economic influence has been heavily hyped, but it definitely is a powerhouse that offers Canada major opportunities in coming years, says a new report by BMO Nesbitt Burns Inc.

The Canadian economy has remained too devoted to the U.S., our traditional trading partner, and Canada should be looking to diversify, writes chief economist Sherry Cooper.

“While China could soon become the most important trading partner of the U.S., we remain fixated on yesterday’s strategy — bolstering economic activity with the U.S. to the exclusion of almost all others,” she says. “Rather, we should be developing economic ties with the fastest-growing region in the world — Asia, especially China.”

Indeed, China is already a big factor in the Canadian economy. China has become a central source of low-cost manufacturing competition and a heavy consumer of natural resources. Canadian manufacturers have suffered in China’s shadow, but other parts of our economy have benefited from the lift China has given commodity prices. The demand boosts Canadian resources firms’ profits, which also generates positive results in other sectors.

The macro trends are helping to reshape the Canadian economy, but Cooper worries that the federal government and business aren’t doing enough to exploit the opportunities offered by China’s emergence. Not only are we too focused on the U.S. economically, but political concerns with the Chinese regime are also blunting our ability to do business there, she says.

There are risks: China has a long way to go to get up to Western standards, in terms of corporate governance, accounting standards, corporate law and regulations; the country also faces severe social and environmental problems.

China’s human rights record is appalling. There are also geopolitical issues, such as China’s claims on Taiwan and Tibet, its proximity to North Korea and the fears over its increasing military power. Its massive and rapid industrialization is causing huge environmental problems at a time when climate change is coming to be seen as a dire threat to human survival.

The Chinese government’s biggest concern is internal insurrection, as vast economic disparity widens between the handful of wealthy people and its legions of poor, Cooper says. Upward of 70% of China’s 1.3 billion population still subsist on less than $1 a day.

Cooper does not attempt to minimize these concerns. Rather, she suggests, the Canadian government should be addressing these issues through international coalitions and forums, such as the World Trade Organization and the United Nations, and not through paralyzing economic policy.

“It is not hyperbole to suggest that what is at stake are Canadian living standards,” says Cooper.

Canadian companies must press our federal government to engage with China, and, through tax reform, focus on improving Canada’s competitiveness, productivity and capacity to innovate. “This is the case whether we are competing with the U.S. or China or any other country in the world,” she stresses.

The Harper government has started to engage more directly with China. In mid-January, Finance Minister Jim Flaherty travelled to China to promote bilateral trade, specifically in financial services. Trade Minister David Emerson had made an earlier trip.

Flaherty met with Chinese authorities in the banking, insurance and securities sectors, among other government officials, and later said he pressed the case for Canadian firms to get greater access to the Chinese market.

At the conclusion of his trip, Flaherty noted in a conference call with reporters that Chinese officials had suggested Canada’s banks could be more aggressive in the Chinese market. He was told Canadian banks should be seeking a bigger part in some of the large initial public offerings of Chinese banks that have taken place in the past few years.

“Some banks from some other countries have been more aggressive in China than Canadian banks have been,” Flaherty said. “At the same time, these comments were being said to me in a very friendly and positive way; the Chinese officials were welcoming more aggressive participation by Canadian financial institutions.”

Selling financial services to the Chinese market has long been one of the plums sought by Western firms. Although China has shown a great genius for out-hustling manufacturers, it’s not quite as easy to emulate Western expertise in finance in a country that is still very centralized and without much of a legal system. Markets and property rights are essential to well-functioning financial services, but can’t be developed overnight. The hope for Western firms is that they can help build a capital market and a well-functioning financial system in China, selling their services to its massive market in the meantime.

@page_break@Financial services are also at the top of Cooper’s list of potential beneficiaries of closer ties with China: “The Chinese banking and insurance sector is highly regulated and particularly inexperienced and underdeveloped in modern financial markets and practices. There are enormous opportunities for Canadian banks to provide savings and investment vehicles, personal loans, credit cards, online banking, commercial loans and foreign exchange services — to name just a few.”

At stake is a large, fast-growing market. Not only is there a huge amount of wholesale banking business available, but there is a large and growing retail opportunity.

The majority of Chinese citizens toil in abject poverty, but there are now about 300,000 millionaires and about 130 million in the emerging middle class. Both latter groups are prospective targets for Canadian financial services firms.

Gradually, in the past few years, China has been opening up access to its financial markets. When it was allowed into the WTO in 2001, it agreed to open its doors to financial services firms after five years.

So far, China has been good about meeting its WTO commitments. However, a report that had been scheduled to be issued in mid-December on how China would furnish greater access to foreign competition has yet to be delivered.

In the meantime, the struggle to gain a greater foothold in China has attracted many Western financial services firms. So far, the large insurers, led by Manulife Financial Corp. (see News Briefs, right) and Sun Life Financial Inc. , have been bolder than the banks about venturing into China.

Still, a number of the big banks have moved into Chinese waters. Bank of Nova Scotia claims to have the largest presence in mainland China among the Canadian banks, with offices in Beijing and Shanghai and branches in other parts of the country.
It also has a minority stake in Xi’an City Commercial Bank.

Bank of Montreal, meanwhile, boasts several firsts in China. In 2003, it became the first foreign bank to buy a stake in a Chinese fund manager, Fullgoal Fund Management Ltd. , which now has about US$2.8 billion under management. Last year, BMO was the first Canadian bank to get permission to offer services in local currency rather than simply in foreign funds, and it was also the first firm permitted to sell derivative financial products.

Last year, Royal Bank of Canada was allowed to upgrade its representative office in Beijing to branch status, a move that allowed it to broaden its range of services. This past October, RBC announced a joint venture in fund management — teaming up with China Minsheng Banking Corp. to launch a mutual fund company that is 30% owned by RBC, 60% by China Minsheng and 10% by Three Gorges Finance Co.

CIBC offers a host of services in China as well.

Even though Flaherty was told the Chinese see Canada’s banks as too cautious about expanding, Cooper believes they are punching above their weight class in a fledgling market in which they are competing with the large global players, such as HSBC and UBS AG, along with some U.S. heavyweights.

The big boys of the financial world may be clamouring to exploit the vast promise of the Chinese market, but the efforts have yet to amount to much.

Data from the Daiwa Institute of Research (Hong Kong) Ltd. show that just 2% of bank loans are held by foreign-invested firms. Chinese state-owned banks still control the majority of loans, with other commercial banks and credit co-ops holding the rest.

Similarly, Taiwan-based brokerage firm KGI Securities Co. Ltd. reports that foreign firms accounted for only about 5.6% of life insurance premiums in China in the first half of 2006. The business is dominated by China Life, with its 46% share, and other local firms.

The securities market has been even slower to open. In fact, UBS Securities LLC has just announced that it is the first firm to receive permission from China to take a stake in a local brokerage firm that has a full licence to trade and underwrite securities, manage assets and publish research.

The appeal of China, however, is in its potential. KGI predicts a 16.4% annual growth rate in insurance premiums through 2015. Only 2.7% of the population currently has insurance, and the trends of urbanization, population aging and social security reforms are expected to drive the business for years to come.

Research shows that the country has low penetration in wealth management: upward of 80% of household financial assets are in cash. In 2005, life insurance premiums and mutual fund assets accounted for only 3.5% of total deposits and 7% of household deposits.

A UBS report points to a lack of products as one reason why so much savings remain in cash, noting there were only 181 mutual funds offered by 49 fund managers as of June 2006.

“Nonetheless, we expect inves-tors to diversify their financial portfolios gradually from cash deposits to more wealth-management products,” the report says. “The launch of more innovative investment products by banks, and customers’ greater product awareness, should spur demand for mutual funds, life insurance and other wealth management products.”

It notes that insurance premiums and AUM grew 29% and 94%, respectively, on a compound annual basis during the 2001-05 period.

However, Cooper says, the supply of insurance products in China is underdeveloped.

CHINESE ARE HEAVY SAVERS

There are certainly plenty of funds available to be converted to investment assets, as an estimated US$2 trillion sits on deposit. The Chinese are renowned as heavy savers. Cooper predicts that all kinds of insurance, as well as annuities and other savings vehicles, will be enormously popular in the years ahead.

The challenge for Western financial services firms is to convert deposit assets into higher-returning investment assets. Unlike the banking and insurance sectors, however, in which Chinese authorities have pushed the markets to open up, the investment sector has been slower to reform.

The sector remains in the thrall of interventionist regulators. Daiwa reports that due to the authorities’ concern about speculative activity in the stock market, the China Securities Regulatory Commission recently halted the approval of new mutual funds.

Such a tendency to intervene isn’t likely to evaporate any time soon. “Near term, we see increased risk that the Chinese authorities may introduce further measures to cool the market,” Daiwa cautions.

It’s enough to scare off the timid. But China’s massive market potential, and a lack of genuine growth opportunities here at home, means Canada’s financial firms can’t help but be lured to take the risks. IE