Reforms to China’s capital markets over the last 18 months have been monumental. A number of initiatives have been instigated to bolster foreign investment into China and to improve the domestic market infrastructure to facilitate these capital inflows. While the recent market volatility has dampened some foreign investor interest, this is likely to be a short-term phenomenon.
The last few years have seen increased capital inflows into China following the implementation of both the Qualified Foreign Institutional Investor (QFII) and Renminbi Qualified Foreign Institutional Investor (RQFII) schemes. Both QFII and RQFII apportion quotas to eligible foreign institutions restricting how much they can actually invest in China. Nonetheless, these quotas are becoming more generous and flexible, a point made by Vicky Tsai, head of investor services, China, at Deutsche Bank, speaking at NeMa Asia, held in Shanghai in November 2015.
A spate of countries has been assigned new or more generous quotas, while Chinese authorities have sought to reassure investors on asset safety. Perhaps the most significant reform has been the introduction of Shanghai-Hong Kong Stock Connect in November 2014, allowing investors with Hong Kong brokerage accounts to trade Chinese A Shares while permitting Chinese investors to transact in a limited number of Hong Kong-listed securities. There were inevitable teething issues and low trading volumes, but activity picked up once the market overcame difficulties arising from pre-funding requirements and differences in settlement schedules.
“Pre-delivery was difficult for numerous investors but many of the global custodians and sub-custodians have introduced innovative systems to help overcome the settlement challenges. A prime example would be the Special Segregation Account (SPSA) model which allows the Hong Kong Exchange to verify there are northbound shares available prior to the transaction,” commented Sundeep Verma, co-head of investor services sales, Asia-Pacific, at Deutsche Bank.
Looking forward, there is speculation that a major reform of China’s delivery versus payment system will be announced in the New Year, with many market participants hoping for the introduction of same-day delivery for cash and securities. According to Franky Chung, senior vice president of the mainland division at Hong Kong Exchanges and Clearing, market infrastructures are gathering industry opinion on the matter and will report in due course. In addition, Stock Connect is being extended to Shenzhen and there is talk of a link to London, despite complexities around clearing and settlement due to the time-zone differences, as well as curbs on short‑selling.
But uncertainty remains over the Chinese authorities’ attitudes to beneficial ownership under Stock Connect. Securities are registered in the name of the beneficial owner in a segregated account under QFII and RQFII, but securities are held in a nominee account structure under Stock Connect. China’s regulators have said they recognise beneficial ownership in a nominee account, but it obviously has yet to be tested. “The China Securities Regulatory Commission (CSRC) has not completely clarified the issue around beneficial ownership under Stock Connect. Ultimately, the proof will be in the pudding, as to whether Chinese courts recognise beneficial ownership during an insolvency proceeding,” said Bernie Chew, regional head of network management for APAC at Northern Trust.
Nevertheless, some are calling for Stock Connect to be extended to more asset classes including fixed income, currencies and commodities. In February 2015, the China Central Depositary & Clearing, a mainland depositary, said it would like to see a Bond Connect scheme initiated modelled on the success of Stock Connect.
This should not be surprising. The Chinese bond market is now the third largest in the world (behind the US and Japan) standing 35.3 trillion RMB or US$5.7 trillion, as well as one of the world’s most diverse. As such, Bond Connect would create a linkage between the onshore and offshore bond markets and should it come into fruition would be applied to Chinese government and corporate bonds. It would simultaneously permit Chinese investors to obtain exposure to offshore Chinese bonds denominated in US dollars, euros and Japanese yen.
Some progress has been made. In October 2015, Russia’s National Settlement Depository (NSD) and China Central Depository & Clearing announced plans to launch a cross-border settlement infrastructure to permit direct investment in government bonds between them in 2016, following a memorandum of understanding between the two market infrastructures in June 2015. In a statement, NSD compared the project to Euroclear Bank’s bond, stock and currency settlement services which offers Russian issuers direct access to mainland China’s bond market.
Bond Connect could facilitate investment from bond funds and other institutional investors, but there are reservations. Whereas Stock Connect covers on-exchange traded equities, official data says around 90% of Chinese bonds are traded over-the-counter and bilaterally. The rest is carried out on the CSRC-regulated exchange bond market. As such, a trading link would only cover a small proportion of the Chinese bond market as it will not apply to the interbank bond market.
However, Bond Connect is just one piece of the puzzle. Other reforms have been initiated and are gathering momentum. “Reform is a key area of focus for the authorities,” commented Tsai. Rule changes introduced in July 2015 ease restrictions that had been imposed on foreign institutional investors, permitting institutions to transact in interest rate swaps, forward contracts and bond repurchase agreements without having to seek regulatory pre-approval. Instead, these financial institutions will only be required to file a single page registration form with the People’s Bank of China (PBOC). Firms will also be allowed to scale their bond investments with more flexibility.
This is all part of the regulator’s efforts to bolster the internationalisation of the renminbi. At present, the rules only apply to major institutional investors including foreign central banks, sovereign wealth funds and similar institutions, RMB cross-border trade settlement banks and QFII/RQFIIs. “It is possible the regulators could further expand the scope of eligible foreign asset managers to transact in the interbank bond market to expedite the development of RMB Internationalisation. However, there is currently no time-frame for when the rules will be released,” commented Sophia Chung, head of HSBC Securities Services, China. Currently, foreign bond investors hoping to gain exposure to China’s interbank bond market can only do so through their QFII quotas, and as such, hold just 2% of all Chinese bonds, according to PBOC data.
Room to roam
China has also introduced liberalising measures pertaining to foreign hedge funds and Hong Kong-based asset managers. The first initiative – known as the Qualified Domestic Limited Partner Programme (QDLP) – allowed six established foreign hedge funds to raise a finite amount of capital from wealthy citizens in Shanghai. No single hedge fund was allowed to raise more than US$50 million although reaching the threshold was a challenge. Market experts argue the high hedge fund investment subscriptions of US$500,000 were off-putting to a number of domestic high net worth individuals (HNWIs), while others point out some of the hedge funds were reluctant to spend huge sums of capital to gain proper distribution in what is a very risky market.
This has not deterred other asset managers from seeking QDLP registration. Reports suggest high-profile names all obtained QDLP licences in March 2015. The Chinese government has also encouraged outward investment through the Qualified Domestic Investment Enterprise (QDIE) initiative, launched in Shenzhen in February 2015. This allows mainland, Shenzhen-registered asset managers to invest in overseas instruments.
Nevertheless, Mutual Recognition (MR) is probably the most well-known liberalising policy to impact asset managers. The rules, announced in July 2015 after several years of uncertainty, enable asset managers domiciled in Hong Kong to sell into China, and vice versa, without the former having to enter into an equity partnership with an onshore bank, brokerage or securities firm. Entering into an equity partnership with a mainland financial institution often required Hong Kong domiciled managers to carry out intense operational due diligence at huge cost.
The managers likely to take advantage of MR in Hong Kong will be those running vanilla, straightforward and easy-to-understand strategies such as exchange-traded funds (ETFs), equities and bonds although it may be embraced by more esoteric fund managers in time. While MR obviates the obligation to enter into an equity partnership, distribution as a standalone asset manager in China is not a simple process. Most Chinese investors prefer to allocate capital to domestic fund managers. As such, Hong Kong managers will need to find distribution partners if they are to successfully solicit Chinese investors.
“Hong Kong managers will need to review their distribution models. China is a closed market and MR gives foreign asset managers the opportunity to sell to the mainland, but mainland retail investors might not be familiar with them. As such, foreign fund managers will probably want to distribute their vehicles through Chinese banks or platforms, which have a major role in distribution in China,” said Cindy Chen, country head for securities services at Citi in Hong Kong. Given the clout of Internet platforms in China such as Alibaba and Baidu, some have advised managers look to these outlets. Entering into distribution agreements will mean mainland providers will get a share of management fees, and this will ultimately eat into P&L.
Extending mutual recognition
A report by HSBC in 2014 hypothesised MR could be extended beyond Hong Kong, replicating the experiences of past schemes such as QFII and RQFII. The HSBC paper said Singapore, Taiwan, Luxembourg and the UK were all prospective candidates for MR. Taiwan has strong links and cooperation agreements with China, for example. Meanwhile, Luxembourg and Ireland are the leading domiciles for UCITS and AIFMD (Alternative Investment Fund Manager Directive) compliant managers. Malta is also popular among some of the smaller UCITS and AIFMs. HSBC identified the UK as an outside candidate although said its expertise as a renminbi hub could act in its advantage. The report also predates the recent diplomacy between the UK and China. All of these countries could find themselves benefiting from MR in time. However, the paper questioned whether MR is a ploy to prevent the spread of UCITS in China.
Despite this, interest has been strong. The CSRC said that 100 Hong-Kong based fund managers and 850 mainland managers qualified under MR. However, the regulator has yet to approve any of them yet due to the adverse market volatility, which has resulted in a suspension of initial public offerings (IPOs), share trading suspensions and a ban on short-sales. It is hoped that once this volatility diminishes properly, registrations will be approved and cross-border fund sales will proliferate between Hong Kong and China.
China is opening its capital markets slowly. It often uses the Shanghai and Shenzhen Free Trade Zones (FTZ) as litmus tests for future reforms on a country-wide basis. These reforms are a step in the right direction, and are generating immense interest among foreign institutional investors.