TICKER - Opening Up Beijing Allows Investors To Buy Hong Kong Stocks In Another Great Leap Forward

For years Beijing maintained tight restrictions on capital outflows to maintain financial stability.

For years Beijing maintained tight restrictions on capital outflows to maintain financial stability. But amid growing worries about its huge trade surplus with the U.S. and soaring domestic stock prices, the government last month announced a dramatic liberalization that promises to allow Chinese investors to play a bigger role in global markets.The move will permit mainland Chinese to invest directly in Hong Konglisted stocks for the first time. Until now they have been limited to products developed under the year-old Qualified Domestic Institutional Investor program, which allows fund managers, banks and insurers to apply for quotas to sell products that invest in overseas stocks and bonds.

The liberalization process may not be smooth or easy, though. After Chinese stocks listed in Hong Kong rocketed by 30 percent in the two weeks after the announcement, the government decided to delay the opening, originally scheduled to start in late August, while it rethinks how to proceed. Beijing-based financial magazine Caijing reported that policy makers were worried that a flood of money out of China could depress domestic stock prices and push Hong Konglisted China shares sky high.

Officials are wary of a repeat of the events of 2001, when a decision to allow domestic investors to buy Chinese B-shares, previously restricted to foreigners, prompted the market to surge nearly fourfold before plunging, says Citigroup’s Hong Kongbased China research head, Lan Xue.

China is expected to draft more-detailed rules to govern the liberalization and possibly cap outflows.

Notwithstanding the hiccup, China’s new opening was a welcome development for a country that has approached liberalization gingerly. “I have never before seen a financial services initiative receive such broad support among China’s regulators,” says Peter Alexander, founder of Shanghai-based fund management consulting firm Z-Ben Advisors. Z-Ben predicts Chinese investors will increase their purchases of foreign stocks and funds from an estimated $39.3 billion this year to $137 billion in 2010.

Beijing’s liberalization is driven by two factors, analysts say. First, China needs to offset its huge trade surplus with the U.S., which has caused a massive buildup of reserves and brought pressure from Washington to allow the yuan to strengthen. Easing restrictions on investment outflows would foster a two-way market for the yuan, which is essential if the country is to move toward a more flexible exchange rate regime. Allowing investors to buy Hong Kong stocks is “an important action for widening the channels for foreign exchange to leave the country and promoting basic equilibrium in the international balance of payments,” the State Administration of Foreign Exchange said in a statement.

Second, officials hope that providing investors with alternative opportunities overseas will take some steam out of a roaring domestic bull market. The CSI 300 index of mainland stocks has rocketed 155 percent so far this year, even as other markets have tumbled.

The new liberalization faces some tough headwinds. With the U.S. subprime mortgage crisis roiling world markets, Chinese investors venturing abroad will need a strong appetite for risk. Investors also must reckon with an almost guaranteed decline of the dollar. Those factors help explain why only about a third of the $21.7 billion in QDII quotas have been used so far.