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China tease for new investors
China tease for new investors
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China tease for new investors

28/03/2017

Author : Lawrence Au, Executive Advisor - Asia Pacific at BNP Paribas Securities Services

Quintessence reviews a series of schemes intended to attract foreign investment

img_bp2s_lawrence-au_2017-03-27.jpgConsiderable efforts have been made to reform China’s capital markets to make them more flexible for foreign investors. Three schemes have been implemented to draw foreign flows to the domestic market, with Chinese officials hoping these will help boost liquidity, particularly following the volatility of the last 18 months. But what are these schemes, and how successful have they been?

 

A new investment channel

 

The established method by which foreign investors gained access to China’s domestic market was by applying for an investment quota through the Qualified Foreign Institutional Investor (QFII) or Renminbi Qualified Foreign Institutional Investor (RQFII) schemes.

This process was partially upended following the introduction of the Shanghai-Hong Kong Stock Connect in late 2014, which allowed foreign investors to incorporate A-shares into their portfolios simply by setting up a brokerage account out of Hong Kong. The investment process was streamlined under the Stock Connect, providing foreign investors with a complementary channel into China’s capital markets in addition to their QFII/RQFII quotas.

In December 2016, Shenzhen was incorporated into the Stock Connect, creating the Shenzhen-Hong Kong Stock Connect. Whereas Shanghai is home to big cap stocks and established corporate giants, Shenzhen is more akin to the NASDAQ and its stock exchange offers foreign investors even more diversification within China due to its bias towards mid-cap and technology stocks.

The Stock Connect’s path has had its challenges, but these have been resolved through a combination of regulatory intervention and service-provider intuition. Operational issues around pre-funding did cause problems for foreign investors at first, but custodians have successfully worked to minimise this challenge by establishing Special Segregated Sub-Accounts (SPSAs) or integrated broker-custodian models.

The latter provide investors with seamless access to the Stock Connect through the integrated custodian solution covering the entire trade life-cycle from pre-trade checks and execution to clearing and settlement. Having an end-to-end model appeals to Undertakings for Collective Investment in Transferable Securities (UCITS) and US mutual funds regulated under the ’40 Act, which may otherwise have difficulty accessing China due to its pre-funding arrangements. These arrangements can be incompatible with a fund’s domestic regulatory requirements.

 

The CIBM: a grand opening

 

Despite its USD 6.8 trillion size (as of Q2 2015), foreign investors have yet to tap into the China Interbank Bond Market (CIBM) and they represent a mere single-digit percentage of the overall transactional volume on China’s domestic bond market. This has prompted Chinese authorities to act, offering more foreign institutional investors quota-free access to the CIBM, thereby enabling them to trade in the domestic cash-bond market, which includes credit bonds and rates. In July 2015, the People’s Bank of China (PBOC) announced a relaxation of the rules for foreign central banks and sovereign wealth funds to allow them to trade on the CIBM.

The latest announcement is more generous than many industry experts had anticipated and extends quota-free access to commercial lenders, securities firms, insurance firms and asset managers. Short-term or speculative investors are excluded, although some hedge funds adopting a long-term investment horizon may be able to trade on the CIBM. Inflows have yet to reach critical mass, but around only 20 applications from foreign investors have been received since the authorisation process opened in May 2016.

What explains this slow take-up? One reason is that investors are still learning the CIBM’s operational processes. For example, Chinese government debt is relatively straightforward to gauge, but higher-yielding corporate debt is more complex and requires investors to go through a learning curve. But perhaps the biggest reason is exchange rate volatility and until this stabilises, flows will not increase rapidly.

 

QFII and RQFII

 

China’s liberalising agenda has not bypassed QFII or RQFII, with the securities regulator announcing in September 2016 that asset allocation restrictions on the quota schemes would no longer apply. Historically, foreign investors using the schemes were obliged to invest 50% of assets in securities, while their cash ratio was restricted to 20%. This has now been scrapped in the latest reforms to affect the QFII and RQFII initiatives.

June 2016 saw the biggest news: the announcement that the US would be allocated an RMB 250 billion (USD 38 billion) investment quota under RQFII in the hope that the MSCI would include China in its Emerging Market Index. While this did not come to pass, the liberalisation of the investment quota schemes won favour in the US (now recipient of the second-biggest quota after Hong Kong) and may yet help in the quest to be upgraded by the MSCI.

Other entry points into the domestic China market such as the Stock Connect and CIBM will likely win more market share as foreign investors become more familiar with them. CIBM covers approximately 90% of the bond market, while the Stock Connect and its eventual inclusion of exchange-traded funds (ETFs) will give foreign investors access to about 85% of China’s securities market. If foreign investors can obtain access through the Stock Connect, ETFs or the CIBM, there is limited need to apply through QFII/RQFII, so the quota system could be completely disintermediated and subsumed by the other schemes, which give foreign investors quota-free exposure to China.

 

What are investors doing?

 

The biggest investors in China are Asia-Pacific based, but macroeconomic drivers are encouraging non-APAC investors to consider China in their portfolios. Europe, for example, is in a long period of low, zero and negative interest rates, which is having a major impact on the viability of fixed-income investing. It also has an ageing population and rising pension fund liabilities which, coupled with an inability to draw yields from fixed-income investing, is leaving those investors in a bind. Chinese bonds offer good yields; presenting an attractive option for European capital allocators to meet their liability challenges.

In the US, meanwhile, equities are costly and interest rates are very low, with investors frustrated at the ongoing delays over a long-anticipated rate rise by the Federal Reserve. Again, this may encourage US investors to consider increasing their China bias.

The Chinese market is complex and prone to sudden regulatory change, which can catch investors by surprise. Working with custodians with a physical presence in the country and a wide network of global branches can help investors considering China and using government-backed investment schemes such as the Stock Connect, the CIBM, QFII and RQFII. For more information, please click here.

 

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