By Cian Burke, Head of HSBC Securities Services
Any portfolio investor would jump at the chance to buy into an economy that has been enjoying breakneck growth for more than three decades. Good news, then: China is making its financial markets more accessible.
China’s GDP has increased at least 6% every year since 1977, the longest unbroken spell of such rapid growth in history. China is now home to the second-largest economy in the world. If measured using purchasing power parity, China’s economic output has already surpassed that of the U.S.
As an economy evolves, so do its financial markets. China’s bond market has grown from virtually nonexistent to being the world’s third largest. And as a country, China has the second-largest stock market by trading volume and third largest by market capitalization.
But China’s financial markets are an anomaly: despite their tremendous size, they have been largely out of reach for global portfolio investors.
Years of capital restrictions have isolated China’s financial markets. Outward portfolio investment (domestic investment in foreign securities) amounted to just 3% of GDP in China, compared with 49% of GDP in the U.S. The contrast is even starker for inward portfolio investment (foreign investment in domestic securities): only 4% of GDP in China versus 86% of GDP in the U.S..
China is opening up gradually. There are currently two schemes governing inward portfolio investment: Qualified Foreign Institutional Investor (better known as “QFII”), and its RMB-denominated cousin, Renminbi Qualified Foreign Institutional Investor (better known as “RQFII”). As the names suggest, both programmes are limited to institutional investors, rather than retail investors.
Of the two, QFII has a longer history. It began in 2003 to allow overseas institutional investors to invest in China’s financial markets. Those approved must convert their foreign currency into onshore RMB before they can begin investing. The initial aggregate investment quota was $4 billion. It has since gone up to $150 billion.
RQFII is the RMB-denominated version of QFII. Approved institutional investors must use offshore RMB to invest in China’s financial markets. The programme began in Hong Kong in 2011, starting with an initial investment quota of RMB 20 billion that has since been raised to RMB 270 billion.
RQFII has also been expanded to cover other countries. In 2013, the UK was granted a quota of RMB 80 billion, while Singapore was granted RMB 50 billion. Earlier in the year, France, Germany and Korea were each granted RMB 80 billion. And recently, Qatar was granted RMB 50 billion, and Canada was granted RMB 80 billion. Today, the total global quota amounts to RMB 720 billion.
China’s size means that any loosening of its capital restrictions will matter for all, and the regulators have taken a cautious and systematic approach in its opening-up to the world. Shanghai-Hong Kong Stock Connect, which launches on the 17th of November, is China’s latest programme to lower its wall of capital controls and follows the same path.
Announced in April by Chinese premier Li Keqiang, Stock Connect marks a milestone in China’s financial integration with the world. For the first time, investors within China – both institutional and retail – will be able to directly trade foreign securities, while investors outside China – both institutional and retail – will be given direct access to China’s stock market.
Initially, the programme will only involve the stock exchanges in Shanghai and Hong Kong, and the two channels – northbound to Shanghai and southbound to Hong Kong – are subject to both a daily quota and an aggregate quota. But if history is a guide, the quotas will be increased and the programme expanded.
The potential of Stock Connect is staggering. By way of Hong Kong, it can alter the dynamics of global financial markets.
Global portfolio investors have had limited access to the China growth story, and the hunger is out there. Turnover on the Hong Kong exchange has risen sharply since the announcement of Stock Connect, in part because investors are anticipating that substantial inflows will drive up share prices once the “through train” is on the tracks.
We also think there will be demand from international index investors. Once the Shanghai exchange becomes broadly accessible, it is only a matter of time that A-shares, shares that trade on Chinese stock exchanges, are included in emerging markets indices such as FTSE and MSCI, a move that will drive extra demand from exchange-traded funds.
China’s financial opening-up to the world not only provides access to the country’s huge savings, but will also lead to a more diversified and stable global investor base. More international companies may choose to list in Hong Kong now that they can tap “southbound” Chinese capital. And in the future, IPOs in China may become global affairs as international investors, both institutional and retail, can “go north” via Hong Kong.
Relative to other financial systems, China still cannot be described as open. But the walls are coming down. By gradually removing its capital controls, China is allowing global portfolio investors to buy into its amazing growth story.