The liberalisation of Chinese capital markets and strong political support for long-term institutional investment is driving the rapid expansion of investment possibilities for both foreign and domestic institutions in the world’s second biggest economy.

 Incremental reforms by China’s financial authorities are allowing greater scope for active management of government and government-affiliated funds, meaning large Chinese institutions are increasingly pursuing investment strategies that see them increase their contribution to total financing in the economy.

Investment by large institutions in social projects such as infrastructure, small-business development, social housing and education is by no means a new phenomenon in Asia. The trend overlaps well with the broader objectives of Asian governments such as boosting domestic consumption and putting accumulated forex reserves to enhance economic development, according to Hon Cheung, Regional Director of Official Institutions Group of SSgA. “There’s been an APEC and ADB focus on issues such as income inequality, environmental protection and sustainable growth. The role of infrastructure development in boosting economic growth is well established in international forums.”

China’s attempts to rebalance its economy have struggled due to the dominance of bank lending in the financing mix, however, the accelerated pace of financial reform witnessed in the past 18 months is starting to take effect, and the authorities’ objective of a “multi-layered capital market” is slowly beginning to take shape.

Bank lending as a percentage of total social financing fell from 58% in 2011 to 52% in 2012. The share of lending by the Big 4 banks is also falling, reflecting the ongoing diversification of the financing matrix. Much of this growth has come from the trust sector, whose AUM rose to RMB7trn ($1.13trn) in 2012. Whatever the risks associated with some of this financing, they are clearly a dynamic force and are a source of pressure on the regulators to innovate within the formal system.

Recent political developments at the March “Two Sessions” in Beijing appeared to signal a strong commitment to continued reform in this regard. Arguably the most significant is that Lou Jiwei, the current head of CIC, will become the next Minister of Finance. Lou’s experience at one of China’s most significant SWFs will bring a significant change of approach to hugely powerful Ministry of Finance.

“China faces a similar situation to other Asian economies that have experienced rapid economic development,” SSgA’s Cheung told IPA. “In Asia, there are essentially public sector two sources for infrastructure funding. The first is fiscal surplus, the second is forex reserves. There’s a clear policy inclination to create inclusive growth and boost domestic consumption. Infrastructure investment has a high foreign content so forex can be easily used to fund it.”

Although relatively small in absolute financing terms, Chinese government and government-affiliated institutions are participating in this shift through increasing participation in both capital markets and social financing programs. The NSSF has led the way, investing heavily in social housing projects and last year increasing its PE allocation by 50% to RMB30bn, with further hikes expected in the future.

Other recent developments have continued the theme of gradual diversification of China’s capital market structures and the role of large funds within them. In January this year, the NSSF signalled its intent by opening 30 new stock trading funds, the most since 2008. In March, CSRC permitted the housing provident funds, which have a total AUM of around RMB2trn, to invest in capital markets.

China Development Bank stated in January that it will allocate over half of its RMB funding in 2013 to projects related the government’s recent urbanisation drive and is increasing lending to China’s western regions.

Meanwhile, a trial scheme for specialist local government bond funds to support SME debt issuance also reflects a new development in the social financing structure. More broadly, policy support for fixed income market development continues, while brokerages and insurance companies are also becoming more active participants in the financial system. Each of these steps represents an incremental expansion in the role of government-controlled funds and other financial institutions as a source of financing.

The accelerated pace of reforms is also creating interest among foreign investors. In the expansion of the QFII and RQFII scheme, the Chinese authorities have shown a clear preference for government-affiliated entities and well-established long-term investors, particularly from the Asia-Pacific Region.

“Accessibility is increasing as China opens up its capital account. China’s core-infrastructure has developed significantly but I would say there are selective areas where further development is sensible. It fits well with the shift to domestic growth generation,” says SSgA’s Cheung.

In spite of clear regulatory improvements in recent years, broader involvement of private and foreign capital in financing social and infrastructure projects remains a relatively marginal trend in China and the pace of development will remain gradual. But as China seeks new ways to create growth in the economy, its significance looks set to grow amid a broad-based regulatory loosening. Greater institutional participation in deal flows will increase the scrutiny on deal financing and help improve overall efficiency of capital, another policy objective.

“One question to ask regarding systemic risk is - are these projects fiscally sustainable?” says Cheung. “There are also the usual deal-specific risks embedded in the each project. Also, as we come out of the low interest rate environment, there may be concerns over the impact of this on financing costs as well as the management of interest rate risk.”

However broadening the investor base within social financing structures is ultimately desirable for China and fits well with several key policy objectives.