How R-QFII could unlock China’s capital markets

Fund managers are salivating over the prospects of renminbi-denominated investor flows into China. The full potential will take time to develop, but it could become the primary means of investing into the mainland.

  • 08 Sep 2011
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When the man tipped to be China’s next prime minister announces that he wants to see renminbi-denominated investment flows into his country, the world’s asset management industry is bound to sit up and take notice.

That’s exactly what Li Keqiang did while visiting the former British colony for three days from August 16-18. Amid other announcements about financial liberalisation, Li said that R-QFII would soon proceed, and that Rmb20 billion (US$3.13 billion) would initially be authorised for investment from the renminbi held in Hong Kong.

On the face of it this isn’t such a big deal. The renminbi-denominated qualified foreign institutional investor scheme, to give it its full title, is very small considering the Rmb550 billion, or US$86.07 billion, of offshore renminbi languishing in Hong Kong. The initial applicants are all set to be China-linked too, meaning that this amounts to the mainland using its own companies to feed itself.

But market players, whether the offshore arms of mainland securities and asset management companies, or international institutional investors, are enthused about the potential of the scheme.

“Harvest is gaining a lot of interest from retail banks, private banks and institutional investors on R-QFII,” says Michelle Chua, business development manager for Asia at Harvest Fund Management, one of China’s largest fund managers and a likely R-QFII recipient. “We have also received a lot of requests from overseas.”

The belief is that Beijing is launching R-QFII as a small pilot scheme to allow offshore renminbi into its local capital markets. If it succeeds the authorities should deepen the quotas and invite more participants, much as it has done with the original QFII scheme since its launch in 2003.

The potential for R-QFII is tremendous. Hand in hand with foreign exchange liberalisation it should eventually offer investors a direct means to access China’s capital markets through its own currency. That is a goal most asset managers are prepared to be patient for.

Mini-QFII to R-QFII

R-QFII may sound like a flashy new means to take advantage of the developing offshore renminbi market, but in fact the basic idea has been around for well over a year. It used to be informally known as mini-QFII.

The basic idea was that the offshore, Hong Kong-based arms of major Chinese asset managers and securities companies would be allowed to accumulate money from foreign investors that they could then invest into China’s markets.

The concept came about because these very divisions felt frustrated that while their international rivals gained access to China via QFII, they could not.

Beijing astutely observed that using these companies to invest could help to solve another issue: the lack of investment options for the renminbi being amassed in Hong Kong.

“Hong Kong now has Rmb550 billion and its investment uses are limited. On the other hand the domestic money market is tight, so it makes sense for China to create a manageable channel to funnel one to the other,” says James Wang, chief investment officer for Citic Securities Investment Management.

Even with mini-QFII the plan was always to use offshore renminbi as the source of funding for mini-QFII, partly because of the lack of investment options, and also because it made it easier to move the currency into China without placing yet more pressure on the People’s Bank of China (PBoC) to sterilise these FX reserves.

But while discussions were ongoing about mini-QFII for months, and indeed Asiamoney wrote about the potential in our June edition, nothing about the programme was officially announced.

That made Li’s public statements about R-QFII especially exciting. Here finally was a senior Chinese figure saying that these investment plans would proceed.

R-QFII structure

Official details about R-QFII remain scarce, including the timing of the scheme’s launch, and the initial participants (something we feel Beijing got wrong, as we discuss on page 12). Even the likely applicants don’t yet know the process.

“The key challenges from regulatory perspective at the moment is that before the announcement of the detail regulation, all the product and operational arrangement cannot be finalised and market players need to ensure their readiness and time to market for product once the details are available,” confesses Harvest’s Chua.

While such details remain scant, Asiamoney can offer the following insight from conversations with several applicants and market consultants.

Any company being approved for an R-QFII quota has to invest into China via an open-ended Hong Kong unit trust, not alternatives such as a Luxembourg-based UCIT or Cayman-domiciled funds.

That is unlikely to be a popular structure with Chinese houses. It means that they have to be made available to the public at large, and to do so they will have to pay Hong Kong banks about half their commission to market the funds within the city via their branches.

One expert says that the Chinese securities firms and asset managers are lobbying Beijing to allow a private placement structure, which circumvents the need to openly market the fund, but he believes that this is unlikely to be allowed, at least initially.

Applicants have to have an existing Hong Kong fund licence, and they have to be able to demonstrate that they have at least one public fund already up and running. The latter criterion helps explain why some offshore divisions of Chinese asset managers have set up funds in Hong Kong over the past year.

The much-bandied around figure of a Rmb20 billion initial quota for allocation looks accurate, as does the expectation that funds will have to invest 80% of assets into the local bond market, and 20% into equities.

No official word on approved fund managers has been revealed. However a senior consultant who is speaking with the regulators and advising several aspiring firms believes that 13 companies will be approved to conduct R-QFII; six of which will be securities houses and the other seven asset managers.

On the securities front Citic Securities, CICC, Haitong Securities, and Guotai Junan Securities are shoe-ins to get approval. Additionally Shenyin Wanguo Securities and China Merchant Securities are strong contenders for one of the remaining two spots, and Guosen Securities and Everbright Securities are also in the running.

On the fund manager side Da Cheng Fund, China Southern Fund Management, ChinaAMC, Harvest Fund Management, and E Fund Management are all virtual lock-ins. Meanwhile China Universal Asset Management, HuaAn Asset Management, Bosera Asset Management, and GF Asset Management are fighting for what is likely to be the other three spots.

Details about how the fund managers will shift capital in and out are also unknown, but in all likelihood R-QFII will follow the example of QFII. This means that funds investing into China under QFII funds have to place at least 70% of their assets into the mainland and they are only allowed to shift liquidity (i.e. move money in and out of the country) for one specified day each month.

This similarity of structure is little surprise, given that the two original writers of the QFII rules – Wang Xue Song and Guo Song of SAFE – have returned to write the rules surrounding R-QFII.

Plugging in the loopholes

It may look like business as usual for Beijing’s inscrutable regulators to offer no clarity over the likely initial R-QFII candidates, the size of their individual quotas, when they will be approved and when they will be allowed to begin investing.

But the silence around such details likely hides uncertainty among the country’s own ranks.

R-QFII reaches a long way into the heart of an issue that makes Beijing nervous: foreign investor money entering the country via its own currency to invest in its assets. Fears of foreign exchange manipulation abound, as do concerns about the impact on China’s bond markets. These concerns have led to the highly limited nature of the programme, and the relatively leisurely way with which it is being launched.

“Hong Kong has put lot of emphasis to push forward but when we spoke to the CSRC in Beijing we were told R-QFII is not a priority,” says the consultant.

While China’s control-obsessed regulators cannot predict every vagary of this budding market, they are doing their damndest anyway, speaking to every likely securities house and institutional investor that will take part, together with regulators such as Hong Kong’s securities and Futures Commission and advisers over the risks and conflicts of a launch date. Including the earlier discussions surrounding mini-QFII, these talks have been going on for many months already.

Derivatives are of special concern. Beijing is keen to stamp out every means by which they can be used to manipulate or speculate on the market via R-QFII. It’s an unwinnable war – some bank somewhere will inevitably manage to set up derivatives, whether over synthetic or physical positions – but the regulators want to close off as many loopholes as it can.

Focus fears

The lack of clarity over the launch date also stems in part from the investment focus of R-QFII, namely onshore bonds. That focus makes R-QFII a very different beast to its predecessor, the original QFII, which is heavily equities-focused.

“The original round of QFII was largely limited to equities because betting on fixed income would have largely been a bet on renminbi appreciation, which was the opposite to what the government wanted to happen,” says Wang.

The fact that investors would use renminbi to invest eases such worries to some extent, but concerns over investor motivations may leave officials hesitating to fast-track what is, for the time being, a small but invasive investment scheme.

However one plus point for approval must be the fact that China’s money supply is tightening, courtesy of concerted action by the PBoC.

Timing is key

Another concern among China’s officials is that they will launch R-QFII right into a market collapse, as happened with the qualified domestic institutional investor (QDII) programme.

That scheme was conceived for locally-approved investors to buy offshore assets, making it the mirror image of QFII. But Beijing launched it in 2007, just as the credit crunch settled into the world’s markets. Less than a year later the crunch become the global financial crisis in full, causing asset prices across the world to fall – including in the new QDII funds.

“If QDII had launched at the end of 2008 or 2009 it’s early size would likely be big now, but unfortunately it launched in 2007, before the global financial crisis, so a lot of investors were negatively affected at first,” says Wang.

As a result the funds still struggle to gather investor demand today.

Opinions differ over the eventual launch date. Many observers feel the fact that Li mentioned this publicly means a launch is likely quite soon. But others are less optimistic.

“We spoke with Xue Song [the R-QFII rules writer] recently, and she said that she had not been told by her boss that finalising the regulations was urgent,” says one banker, who believes R-QFII will not launch until the end of the year.

Wang of CSIIM is even more cynical. “It’s difficult to launch this before the end of the year,” he says, “but it would be good to at least get details of the policy by then, such as the successful applicants, the quotas that they will get and official confirmation of what they can invest into.”

Aiming to expand

While the programme will only initially include that lucky 13, the expectation among market participants is that Beijing will expand the R-QFII once its initial problems are ironed out.

While that’s good news it’s likely to take some time – most likely a year or more.

“We will just build up our relationship with those institutions [getting involved] and seeing whether we can keep abreast of the developments and practices in preparation for further opening,” confesses Ben Kwong, chief operating officer of KGI Securities Hong Kong.

Wang believes that Beijing will wait at least six months after R-QFII is launched to assess the transfer and settlement of assets before deciding whether to expand the scheme.

In part this wait will be necessary because the R-QFII involves so many regulatory overseers, including the PBoC, the China Securities and Regulatory Commission (CSRC), SAFE, and the SFC.

Only when they are all happy will R-QFII expand, most likely to other Chinese players, including smaller asset managers and securities houses.

But two sets of onshore market participants will be excluded – China’s banks and insurers. This is down to a regulatory turf war; banks and insurance companies are respectively regulated by the China Banking Regulatory Commission and the China Insurance Regulatory Commission, whereas R-QFII is being pushed by the CSRC and PBOC.

It’s likely that a compromise will eventually be reached, but given the sensitivity of letting the banks have full sway in shifting offshore renminbi into the country it could take time.

Foreign players are only likely to gain access to R-QFII when it expands for the third time – and that’s assuming Beijing hasn’t written into the rules that participants have to be affiliated to mainland companies.

“It’s unclear whether the regulation surrounding R-QFII that will means that only Chinese institutions can apply,” says Cheeping Yap, head of securities and fund services in Hong Kong for Citi. “We don’t believe that this will be the case; however it does look as if all the participants in the pilot scheme will be Chinese companies.”

If foreign companies are allowed into R-QFII, they may be restricted to institutions or asset managers with renminbi-denominated assets. That is likely to lead to several international fund managers setting up renminbi accounts in the coming year to prepare for such an opportunity.

Far-reaching possibilities

One way of assessing R-QFII’s potential is to compare it to original QFII. That scheme’s present liquidity stands at almost US$20 billion, and Harvest’s Chua notes that R-QFII quotas should be benchmarked against the largest QFII individual quota of US$800 million.

But the scheme could become a great deal bigger than that.

QFII was set up to get foreign investment into China as part of China’s efforts to join the World Trade Organisation. That goal has long-since been achieved. Beijing’s new objective is far more ambitious: to turn the renminbi into an international currency equal to the US dollar.

This is a task years in the making. Beijing has already begun with the internationalisation of its currency via trade settlement, but another means to spread its use is to encourage more people to buy renminbi-denominated assets. The best way for Beijing to do that with investors is by giving them more appealing options – and that means offering onshore market access.

Harvest’s Chua notes that onshore bond yields can be 150 to 200 basis points higher than equivalent offshore renminbi deals, and onshore funds can also buy 20% of equities too to act as a kicker to returns.

Add to that the potential for China’s authorities to loosen the rules over equities investing and renminbi fungibility and R-QFII could replace QFII as the primary means for foreign investors to access China’s capital markets.

“R-QFII’s potential makes it important for Hong Kong. If Beijing supports it could become a gateway for renminbi investment into the country, especially if the policies move from no FX conversion to FX fungibility,” says Yap. “When that happens it will position R-QFII extremely well to tap into the Chinese stock market as well as bonds, which is massive. It would change the landscape on how investors tap into China; they would prefer going via R-QFII than via QFII.”

Plus if China wants the renminbi to become a reserve currency, as appears to be its intent, it will need to offer central banks bonds in which they can place the renminbi that they accumulate. Beijing will not be able to issue enough into the offshore renminbi bond market enough to meet that purpose, so it has to offer access to its onshore market. R-QFII paves the way to that goal.

“If the renminbi is to really become a global reserve currency, anybody using it as such will need to exchange the money into renminbi-denominated bonds,” says Wang. “It’s an important step for renminbi internationalisation.”

R-QFII’s size and launch may not yet be finalised, but the programme marks a potentially vital step in a plan with far-reaching objectives. If successful, it could help Beijing usher in the full internationalisation of its currency, while giving offshore investors access to the world’s largest emerging economy via its appreciating currency.

Viewed from that perspective, it’s no surprise that China’s premier-in-waiting was so keen to announce it, even if he did lack specifics.

  • 08 Sep 2011

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