Qualified foreign institutional investors (QFII)
The QFII scheme, which was introduced in 2002, allows foreign institutional investors to invest in China’s capital markets, subject to first obtaining a QFII licence from the China Securities Regulatory Commission (CSRC) and then an investment quota allocated by the State Administration of Foreign Exchange.
On Jan. 14 2013, Guo Shuqing, chairman of the CSRC announced that the quotas for qualified foreign institutional investors have now increased to $80 billion from $30 billion, and that five firms have been granted licence to trade including Credit Suisse, Morgan Stanley, UBS AG and BNP Paribas. Current investments by QFIIs are estimated to account for somewhere between 1.5 percent and 1.6 percent of the total investments in China’s A-share markets and Guo expects a ten-fold increase in that percentage. 2012 also saw 72 new QFIIs approved by the CSRC, a record high for the number approved in a single year.
“Although the amount of QFII quota after expansion is still relatively small compared with the total volume of the A-share market, such expansion launched by the authorities is favourable news and represents China’s efforts to further open up its capital markets to foreign investors,” say David Livdahl and Jenny Sheng, partners at Paul Hastings, continuing that: “We have been asked by clients about the developments of QFII regime and some detailed questions on which current rules are silent. With the expansion of the QFII programme, more foreign investors are expected to seek legal advice with regard to their plan to engage in the QFII programme.”
Guo’s comments have followed a ramping up of China’s QFII approval process which started in 2012, with CSRC allocating 72 QFII licences, compared to 29 and 13 in 2011 and 2010, respectively. Annual investment quotas have also risen dramatically in 2012, reaching $15.8 billion, as compared to the previous nine year where it had never exceeded $3.5 billion. At the end of 2012, 207 foreign investors had been allocated a QFII licence since the scheme’s introduction.
“We have seen this trend where the regulatory regime is evolving and developing towards one of the objectives which is to provide more flexible channels to foreign investment,” states Tom Chau, partner at Herbert Smith Freehills.
However, the total amount of foreign money allowed to enter the domestic stock market remains small and the new rules do not increase it. Reuters reports that the combined foreign investment in China's stock market accounts for only 1 percent of total market capitalisation. It’s clear that foreign appetite for Chinese equities has shown some signs of increase in recent months, especially in Hong Kong, but the weak performance of stock-focused QFII funds and complaints about high fee structures - has dampened appetite.
Alongside granting licences, the regulator has also removed the $1 billion limit for foreign sovereign wealth funds, central banks and monetary authorities buying assets through the QFII programme. A new top limit hasn’t been specified as of yet, but funds can now apply to invest over $1 billion. This change has been warmly received in the market, as funds such as Qatar Holdings and Hong Kong Monetary Authority have already been approved to invest up to $1 billion, Reuters reports.
Overall sentiment is positive: “The regulators have made efforts to increase transparency in China’s capital markets in the past year, “ say Livdahl and Sheng, “For example, the CSRC issued The Guiding Opinions on Further Deepening Reform of the System for Offering of New Shares last April. The CSRC Guiding Opinions focus on information disclosure, pricing control and removal of the lock-up period. The CSRC Guiding Opinions also detail the liabilities of issuers, sponsors, law firms and other intermediaries. The reforms brought by the CSRC Guiding Opinions are certainly welcomed by foreign investors because it will increase transparency, reduce insider trading and address the problem of overvaluations.”
Challenges in China
Lawyers point out that several challenges still remain when it comes to investing in the nation’s capital markets. One, which the government has taken steps to address are the foreign exchange controls. The regulator distinguishes between open-end China funds and other QFIIs, but has now allowed open-end China funds to remit money on a weekly basis compared with the monthly basis stipulation under the 2009 rules. The remittances are also not subject to the regulatory body’s approval whereas previously any amount over $50 million was. For QFIIs other than open-end China funds, the remittance of investment and profits no longer need approval.
“The relaxation of foreign control is definitely a positive development for the investment market,” says Chau. “The investment regulations have to prepare to accommodate the forthcoming changes.” While Livdahl and Sheng affirm that “the rules are favourable news to foreign investors and may attract more investment in the market by QFIIs.”
Foreign exchange restrictions, aside, Chau elaborates that “Investors also have concerns about the corporate governance standard of PRC companies. Investing in China is expected to bring investors considerable and attractive returns, while the basic consideration is the safety and quality of the investment target. More stringent measures on corporate governance issues to be imposed by the regulators on the listed companies will also serve a positive element to attract foreign investors to participate in capital markets in China.”
Time for taxation
Sources point out, however, that uncertainty remains, especially in the area of taxation. There have been longstanding questions as to how QFIIs should be taxed on their capital gains, due to a lack of published rules by the authorities. Market sources comment that in practice, Chinese authorities – for the most part - have not yet started collecting tax on QFIIs’ capital gains. At the time of writing, CSRC has been reported to be very close to finalising the capital gains rules, however, regulations have yet to be published.
“There have not been any clear tax rules as to the profits gained by QFIIs in the China A-share market and it has been a source of frustration for QFIIs for a long time,” confirm Livdahl and Sheng, concluding that “Certain news published on the website said that a final policy is likely to be formulated by the regulators to levy a 10 percent tax on profits gained by QFIIs. We think that a clear tax rule will certainly increase the transparency of the QFII regime and eliminate uncertainties faced by foreign investors. A 10 percent tax on QFII profits appears to be reasonable because similar levels of tax have been levied in many other countries in the world, such as the U.S. and Canada.”
What now?
Sources agree that these changes together with the acceleration of the QFII approval process are an undoubtedly encouraging development, clearly marking China’s intention to attract more foreign investment. Lawyers agree with Livdahl and Sheng, however, who lays out a roadmap for the future, saying: “A key challenge faced by many foreign investors is the comparatively weak legal environment in the PRC capital markets. From our perspective, compared with increasing the investment quota for foreign investors, the improvement of the quality of China’s capital market and Chinese companies are the key measures to attract long-term investors. Therefore, the regulators should now put more focus on the oversight and punishment of financial fraud and insider trading as well as enforcement of disclosure obligations by listed companies.”
China widens investor access to over-the-counter market
By Pete Sweeney
China is giving investors greater access to its over-the-counter (OTC) market as Beijing moves to expand access to credit for small, privately-owned firms that are now largely shut out of the county's financial system.
The new rules, published by China's National Equities Exchange and Quotations Co Ltd (NEEQ), which operates the OTC markets, allow participation by individual investors with over two years of investment experience and three million yuan ($481,300) worth of securities assets, and by new classes of institutional investors including trusts and wealth management funds.
The regulations, which are effective immediately, also lifted a previous restriction that limited investors to 200 per issue.
China's OTC market, which focuses on facilitating private placements in smaller Chinese companies - in particular technology firms - was originally launched in Beijing in 2006, with around 200 firms trading on the platform.
But analysts and participants complained that the lack of a clearing mechanism for trades, plus the limit of 200 investors per issue, kept it short on liquidity.
However, the China Securities Regulatory Commission (CSRC) has recently begun encouraging firms currently stuck in queues for listing on the mainland exchanges to consider alternative routes to raising capital.
In addition to encouraging companies to look into bond markets, the CSRC has already lowered administrative barriers to listing abroad and has now increased access to another capital channel by increasing access to the OTC market.
In the name of rebuilding market confidence shaken by stories of insider trading, the CSRC has effectively suspended consideration of IPO applications until March while underwriters, auditors and regulators double-check financial statements of applicants.
The suspension also satisfied a long-standing petition from the mainland investors that IPOs be halted in order to prevent new issues from diluting valuations, and is credited by some analysts for setting off a massive rally that has seen the Shanghai Composite Index gain around 25 percent since Dec. 4.
China central bank takes lead in economic reform push
By Kevin Yao
China's readiness to bend retirement rules to keep arch-reformer Zhou Xiaochuan at the helm of the central bank signals clearly that new Communist Party chiefs want to speed economic reform in the country's most critical development phase in three decades.
Central bank insiders interviewed by Reuters say the People's Bank of China (PBOC) is the country's most potent force for reform in the face of powerful vested interests, echoing sources with leadership ties who last week said Zhou would keep his job despite reaching the mandatory retirement age of 65.
Keeping Zhou ensures that the PBOC will remain a trusted instrument through which China's leaders can enact financial reforms designed to boost free markets and private enterprise, rebalance the economy, reinvigorate growth and ultimately heal a socially divisive rift between the country's rich and poor.
"Governor Zhou has been rather bold in spearheading market reforms and sometimes does not care about the possible repercussions," said a PBOC official who requested anonymity due to the sensitivity of the matter. "They really need someone who can sustain the reform momentum."
The reform agenda espoused by Party leaders Xi Jinping and Li Keqiang is not always popular with the local government officials, state-backed business and cosseted national lenders who would find their power bases fundamentally weakened.
Liberalising interest rates, for example, would hit fat lending margins at state banks.
Expanding capital markets would end subsidised access to funds for state-owned enterprises and cut private sector finance costs while creating investment options beyond real estate -- cooling the property speculation that lays at the heart of the local government corruption and debt risks.
The PBOC has a track record of getting the job done in the face of entrenched opposition.
It has modernised domestic bond and money markets, laid the groundwork for short-term market instruments to manage bank liquidity and credit, while simultaneously creating mechanisms that allow the PBOC to resist pressure from growth-obsessed local officials to constantly tweak interest rates.
Indeed, the last 12 months have produced the most important package of interest rate, currency and capital market reforms since the landmark July 2005 break of the yuan's peg to the dollar -- and all in a year when political change at the top of the party was supposed to stall change elsewhere.
That's despite a clear clash with the China Banking Regulatory Commission on the liberalisation of interest rates.
"Big banks were definitely against interest rate reform, but they could not openly oppose it," said Zhao Qingming, senior economist at China Construction Bank, one of the so-called "Big Four" state banks.
When the PBOC proposed doubling the yuan's trading band to 1 percent last year, it worked hard to soothe fears of the Commerce Ministry that it would not harm the export sector, according to sources familiar with the situation.
"We were persuaded that further sharp appreciation was very unlikely," said a senior researcher with the Ministry.
Arguably it was Zhou's 2005 success in engineering a break of the yuan's dollar peg in the face of staunch opposition from the Commerce Ministry that most clearly states his credentials.
Pragmatic reformer
Yu Yongding, a respected economist and leading advocate of major currency reform, recalls the wrangling required to make the decision on a PBOC monetary policy committee stacked with senior officials from a variety of government departments.
Yu, an economist at the top government think-tank, Chinese Academy of Social Sciences (CASS), sat on the policy panel from 2004 to 2006, as the PBOC went head-to-head with critics of revaluation who complained that exporters could not withstand any rise in the value of the yuan.
"Their views had to reflect the stance of their respective departments," Yu told Reuters, recalling the logjam as pro-export officials railed against the suggestion of some other committee members of a revaluation of as much as 10 percent.
Yu says Zhou's pragmatic approach defused the row, agreeing to a small initial rise of 2.1 percent in the yuan's value against the dollar, while forging a top-level consensus on the incremental annual pace of currency strengthening that has seen it gain around 33 percent in nominal terms since.
Despite the stronger yuan, China has become the world's single biggest exporting economy while its companies have been forced to make productivity and quality improvements to stay competitive.
Xi and Li, due to take over in March as president and premier, respectively, need to engineer an even more widespread move up the value chain to deliver enough growth to support China's next stage of economic development -- and the transfer of about 400 million people into cities from the countryside.
That's no mean feat given the general conclusion that China's export-oriented, state-driven economic model that delivered three decades of breakneck double-digit expansion, has reached the outer limits of its effectiveness.
Growth in the world's second-biggest economy slowed in 2012 to a 13-year low, albeit at a 7.8 percent rate that is the envy of other major economies.
Many analysts believe China's growth will be nearer 5 percent than 10 by the end of this decade without far-reaching economic reform -- a worry for a government that has pledged to double household income over the coming decade in a bid to close a wealth gap so wide it threatens social stability.
About 13 percent of China's 1.3 billion people still live on less than $1.25 per day according to the United Nations Development Programme and average urban disposable income is just 21,810 yuan ($3,500) a year.
Meanwhile, China has 2.7 million dollar millionaires and 251 billionaires, according to the Hurun Report.
Stalking horse
Using the PBOC as a catalyst for reforms is a smart move, provided the anticipated domino-effect works as expected and relatively straightforward liberalisation efforts trigger more fundamental evolution in China's economic structure.
The PBOC must make bank borrowing costs more market-driven to improve resource allocation and wean the economy off its reliance on state-led investment, analysts say.
But the financial system is dominated by big state-owned banks that channel the bulk of loans to state projects and state-owned enterprises, starving private enterprise of cash.
All of which conspires against the creation of additional investment options for Chinese households, lumbered mainly with low-yielding bank deposits that constrain consumption.
Optimists say that even if it doesn't deliver entirely as anticipated, the PBOC is likely to be more effective in the short-term than trying more politically-charged reforms, such as China's strict system of household registration, or Hukou.
A further advantage of using the PBOC as the instrument for change is that the most important decisions it disseminates are essentially edicts approved by the State Council - China's cabinet - or by the Communist Party's ruling Politburo.
Keeping a reform-oriented Zhou in the top PBOC job ensures the leadership is dealing with a like-mind.
"If we get someone who is tepid and does everything on an even keel, the reform process could be slowed," said Xu Hongcai, a former PBOC staffer and now a senior economist at China Centre for International Economic Exchanges (CCIEE), a Beijing-based think-tank. "We must ensure policy continuity while injecting a new air into reforms."
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