To view a PDF of the full report, click here.
By Eric Johnson
It may be too simplistic to use the “bull and bear” analogy to describe the complex international sentiments toward the main channels through which non-Chinese institutions are accessing China’s US$6.5 trillion equities market.
And yet recent investor activity points to opposite approaches to the Qualified Foreign Institutional Investor (QFII) and Renminbi Qualified Foreign Institutional Investor (RQFII) programs, which as of July 1 gave hundreds of firms a way to put into play a combined US$157 billion.
Each approach – one cautious, the other brimming with enthusiasm – reflects a mutual confirmation of the intrinsic value of Chinese equities, fixed-income products and, increasingly, bonds in a huge investment arena that’s still labeled “emerging” and yet is very much in the global market forefront, given China’s clout as the world’s second-largest economy with a securities market boasting the world’s second-largest market capitalization.
No doubt most of the programs’ participating investors would agree with Rodney Comegys, Asia Pacific head of investments for Vanguard Investments Australia Ltd., who attributes his firm’s recent decision to join RQFII for the first time to the importance of China as “one of the world’s key emerging economies.” Regulators awarded the firm a US$4.5 billion investment quota in January.
“Our participation in this program is supported by the belief that A shares can provide the diversification benefit of spreading risk among a greater number of companies, and will thus offer significant value to investors, including individuals, over the long term,” Comegys told Institutional Investor.
The foreign investment inflow programs were at the heart of a series of financial market reform measures announced between February and June, including a five-fold raising of the investment ceiling for QFII participants to US$5 billion from the previous US$1 billion, and the June granting of a roughly US$38 billion RQFII quota to U.S. firms that hold Chinese currency.
Bearish Tone
What could be called a bear-like investor response to RQFII and QFII is in fact a bow to the yellow lights flashing as China’s economy continues a seven-year-old, government-managed deceleration, the market digests a recent decision by stock indexer MSCI to delay inclusion of China’s A shares in the firm’s Emerging Markets Index, and the investment community recovers from sell-offs that rocked the Shanghai and Shenzhen stock exchanges in June and August, 2015, as well as last January.
Investors in the cautious camp also appear to be giving the Chinese government more time to advance a financial markets liberalization campaign that, according to some analysts, eventually may fully open China’s equity and bond environment to overseas investors.
The liberalization effort is working hand-in-glove with internationalization of the yuan, also called the renminbi, which last year was accepted into the elite club of Special Drawing Right currencies alongside the U.S. dollar, euro, yen and pound maintained by the International Monetary Fund.
One of the most telling indicators of this caution has been a significant slowdown in investment firm applications and awards of new RQFII quotas, from the QFII and RQFII supervisor, the State Foreign Exchange Administration (SAFE). Only 14 new quotas were awarded in the first half of 2016, compared to 61 in full-year 2015, which brought the total quota level to US$76 billion as of July 1.
Among the most recent qualifiers were PIMCO Asia Pte Ltd., which secured a quota of US$270 million; CF Financial Markets (UK) Ltd., which got permission to invest up to US$150 million; and AXA Investment Managers Paris, awarded a US$510 million quota.
Meanwhile on the QFII side, the 36 new quotas announced during the first six months of 2016 reflected a brisker pace for program participation than in 2015, when SAFE approved quotas for 65 firms. Total quotas have now topped US$81 billion, up from US$50 billion in early 2014.
But an increase in quota awards is nothing new, as the field has been growing wider every year, jumping to last year’s level from 56 in 2014 and 36 quotas in 2013. Moreover, many of the latest quotas were new awards for long-time participants such as divisions of UBS, Citigroup and Morgan Stanley. Hong Kong-domiciled mainland asset managers such as E Fund Management (Hong Kong), China Asset Management (Hong Kong) and Bosera Asset Management (International) Co. Ltd. also upped their quotas.
Ten of this year’s first-half quotas were handed out on the last day of the second quarter, including a US$1.29 billion award for UBS AG, a US$338 million quota for Morgan Stanley Investment, a US$650 million investment level for Merrill Lynch International and a US$350 million quota for KB Asset Management Co. Ltd.
Somewhat bearish sentiment also reflect the wider opening of Chinese financial markets. Since 2013, as part of the government financial markets liberalization campaign, the QFII and RQFII programs have been complemented by another door to mainland equities called Shanghai-Hong Kong Stock Connect scheme, which lets non-Chinese trade A shares on the Shanghai Stock Exchange and mainlanders play the Hong Kong Stock Exchange.
The connect program’s “net buy” daily limit for A-share investments is US$1.95 billion – money that theoretically might have made its way into China through QFII or RQFII if not for the connect program. Qualified mainlanders are allowed to invest a combined US$1.58 billion in Hong Kong stocks every day.
Bull Side
So who’s bullish about QFII and RQFII? Included in this camp are asset managers who’ve been participating in the programs for years, many of whom loyally stuck with China A shares through the worst downturns for the Chinese stock markets in 2007 and 2015-2016. QFII launched in 2003 and RQFII in 2011.
Of the 168 quotas granted as of June 29 through RQFII, only one – CIFM Asset Management (Hong Kong) Ltd., with permission to invest US$120 million – has been around since the program’s inception. But firms with 20 of the 273 quotas have participated in QFII since before 2010.
Daiwa Securities Capital Markets and Power Corporation of Canada have each had a US$50 million quota since 2004, while since 2006 the firms Nomura Securities Co. Ltd. and Goldman, Sachs & Co., have been allowed to invest up to US$350 million and US$300 million, respectively.
The two-thumbs-up for QFII-RQFII crowd also includes many asset managers who’ve applauded the government’s gradual relaxing of foreign investor access restrictions. Their patience was rewarded with several major reform steps in the first half of this year.
“There have been meaningful adjustments of the QFII-RQFII program in the past few months” that have made the programs “more convenient and attractive,” says Fred (Jiachun) Chen, executive director and head of QFII/RQFII Business at CITIC Securities Co. Ltd., which through a subsidiary holds a US$210 million RQFII quota. The firm also has a US$300 million QFII quota through a Hong Kong affiliate.
“I personally expect the government to continue to reform and improve the QFII-RQFII scheme as an important part of China’s capital market opening process,” Chen says.
QFII was initially crafted as a foreigner-friendly way to enhance the A shares market without forsaking the Chinese government’s tight foreign currency exchange controls. Participants include asset managers, insurance companies, banks and pension funds. Each participant designates a Chinese custodian bank to handle its securities business and works with Chinese brokers as well as foreign and-or Chinese advisers.
The role of RQFII, which is nicknamed “little QFII,” has been limited to repatriating offshore yuan back to the mainland and into investment targets, which for the most part have been equities. The program initially offered a way home for yuan parked in Hong Kong and Macau, and later expanded to other countries with yuan clearing such as Singapore, South Korea, France, Germany and Britain.
The United States joined the yuan clearing club in June and was subsequently granted a 250 billion yuan (roughly US$38 billion) RQFII quota, thus giving U.S. firms a means to invest Chinese currency on the mainland. Under the agreement signed by China’s central bank and the U.S. Federal Reserve, the United States will become the second-largest RQFII base after Hong Kong. China also agreed to designate yuan clearing banks in the United States.
The U.S.-China agreement came on the heels of deep adjustments to the QFII-RQFII schemes in order to facilitate the gradual, now 12-year-old process of opening China’s financial markets, as well as the Beijing government’s ongoing push to elevate the yuan to the status of a truly global currency.
Addressing an often-repeated foreign investor complaint about money-flow restrictions in China, regulators at SAFE in February slashed to three months a mandatory lock-up period for QFII participants who want to move cash in to or out of China. The previous period was one year.
SAFE also announced that it would “no longer define a unified upper limit on the investment quota of a single institution and assign an investment quota (basic quota) to the institution in proportion to the size of its assets or assets under management.”
Ongoing Reform
But most asset managers want more from China’s reforms. Institutions such as MSCI are also indirectly encouraging China to speed up liberalization. Indeed, what MSCI considers an unacceptably restrictive investor environment was the key reason for China’s failure to win a place on the Emerging Markets Index, frustrating government officials who’ve been lobbying the indexer for firms.
Many foreign asset managers can’t wait for the day when regulators ease a rule that prevents a QFII participant from moving more than 20 percent of its assets out of China in a single month. SAFE’s February announcement emphasized that this rule, as well as a requirement that all money be moved in “batches or installments,” remains in force.
Neil Flynn, an analyst for the Shanghai-based China market consultancy Z-Ben Advisors, says he expects Chinese regulators to continue making adjustments “to push forward MSCI inclusion and encourage FX (foreign exchange) inflows...going forward.”
If you look at recent inbound access reforms, China is moving towards a quota-less, restriction-light environment,” says Flynn, citing the examples of a recent reform to the interbank bond market and the expected launch of a Shenzhen-Hong Kong stock connect program to build on the success of the Shanghai-Hong Kong program. The government has said it plans to launch Shenzhen-Hong Kong Connect this year, probably late in the third quarter. Future connect programs could link the Singapore stock market to mainland exchanges.
In February, the central bank announced the lifting of all investment limits by foreign central banks and similar institutions participating in the Chinese interbank foreign exchange and bond markets, thus offering no-quota access to interbank bonds. The only stipulation is that foreign banks and institutions register every investment; interbank foreign exchange market deals are registered with the China Foreign Exchange Trade System, and bond investments are tallied by the central bank.
“China encouraged institutional investors to invest in its interbank bond market as a means of financial opening up,” according to a Shenzhen Stock Exchange statement. The central bank “PBOC will introduce more QFII (participants) to the interbank bond market with streamlined regulations and no quota restrictions.”
While large-cap, A share equities are currently the chief target for most QFII and RQFII investors, government reforms could generate more interest in the bond market in the months and years to come.
Chinese companies have stepped up bond issues in recent years as a way to manage debt without resorting to fundraising on the volatile stock market. Bonds are also popular among local governments that in recent years, due to the nation’s weakened property market, have sought to diversify away from raising money by selling land to developers.
At the same time, though, the widening of access channels such as the Shanghai- and Shenzhen-Hong Kong stock market schemes, together with the lingering gap between what foreign investors want and regulators are willing to give has raised questions among bulls and bears alike.
Flynn says his questions center on “the long-term viability of QFII and RQFII in their current state,” adding that in his opinion “they need to adapt or die.”
Nevertheless, future adjustments by Chinese regulators toward “a restriction-light environment will be more step-by-step than immediate,” Flynn says. “Our long-term view is that the choice between QFII and RQFII will not matter” to institutional investors in the future, as which program to play will become “a technicality that the back office handles, leaving portfolio managers free to trade China, unrestricted by quotas.”
Vanguard’s Comegys noted that for China and “all emerging markets, trading access can change over time. Currently, we can also access A shares through other programs such as (the Shanghai-Hong Kong) Stock Connect.”
Clearly, there’s no definitive consensus about a future path for QFII and RQFII. Market forecasting in emerging China has never been an exact science, of course, as even the most reasonable predictions can be blown away by a flash of volatility – a fact underscored by dramatic stock market selloffs over the past year.
But unlike other major economies, every China market forecaster starts from the same reference point. That’s because every prediction must in some way revolve around the directives and official comments expressed by the nation’s financial system gatekeepers at SAFE, the central bank, the China Securities Regulatory Commission and similar agencies.
Eliciting one of the latest commentaries that attracted forecaster attention was SAFE Administrator Pan Gongsheng, who doubles as the central bank’s deputy governor, while meeting in March with Blackstone Group LP President Hamilton “Tony” James and Euromoney Institutional Investor CEO Andrew Rashbass.
According to an official summary of Pan’s comments, China “will not resort to capital controls as it did before” but will focus on “risk prevention” and “vigorously promoting trade and investment facilitation.”
“Going forward,” Pan says, “China will focus on advancing structural reform, especially supply-side structural reform, to better balance economic growth, structural adjustment and risk prevention.” The goal will thus be “sustainable and stable economic development.”
Although Pan did not mention investment inflow, his superior Prime Minister Li Keqiang told an economic forum June 27 that the government would “provide more investment opportunities to foreign businesses and foster a fairer, more transparent and predictable investment environment.”
Speaking at the annual Summer Davos Forum in Tianjin, Li promised to “deepen the reform of the financial system, accelerate the improvement of the modern financial regulatory regime and increase the efficiency of financial services in supporting the real economy.” The premier also called on the world’s major economies to “steadfastly advance trade and investment liberalization and facilitation” with China to “build a fairer, more just and open international economic system.”