Published on IPE Magazine (September 2019)
Author: Sun Wei, Founder of ATC Initiative
Notes on 11 Sept 2019: yesterday the big news is that Chinese regulator (SAFE)announced the decision to remove quota on QFII/RQFII. This is another big step in opening up Chinese capital market. Below is an article I have written for the Sept issue of the IPE magazine. It compares various channels for China market access and points out the healthy competition between QFII and the Stock-Connect programs. The article can also be found at: https://www.ipe.com/reports/special-reports/china/capital-markets-all-roads-lead-to-china/10032998.article
As the second largest economy in the world, China’s economic significance is well recognized. However, foreign capital participation in Chinese capital market is very low, although China ranks high in the size of these markets (second largest equity market and third largest bond market). This is largely due to the capital control still in place. But in recent years, there is a clear trend of capital market open-up acceleration and a variety of schemes/channels have been adopted to facilitate overseas investors to access China equity, bond and other markets.
A brief history
Figure 1: Timeline of Access Channels Launched
Source: CSRC, SAFE, PBOC, ATC Research
Figure 1 shows a brief history of Chinese capital market open-up. While some China-savvy investors may argue that there is “B Shares” offering even earlier, people usually count the 2002 Qualified Foreign Institutional Investor (QFII) scheme as the first meaningful access channel for global investors. Almost 10 years later, the RMB QFII (RQFII) scheme was introduced to enable offshore RMB holders to access China domestic capital market, followed by HK Stock Connect, CIBM-Direct, Bond connect etc., introduced at a much higher speed, clearly showing an acceleration of capital control relaxation.
I admit that there are a lot of acronyms discussed here that may cause confusion. For an international institutional investor, in practice, a defining element of a scheme is that whether it require you to move your money onshore before investing (“getting onshore”) or allows you to invest from an offshore position (“investing from offshore”). Let’s examine the channels along these two lines.
“Getting Onshore” Schemes
These schemes require an international investor to convert its currency into onshore Chinese currency (CNY), move the capital onshore to a China regulated bank, use the domestic brokerage service, and invest in Chinese domestic market much like a domestic player. QFII/RQFII and CIBM-Direct belong to this category.
The QFII scheme, launched in 2002, allows a global investor to move international capital onshore to invest in Chinese equities, bonds, mutual funds and stock index futures. RQFII, launched in 2011, is very similar to QFII, the difference being that it is designed for overseas investors who have offshore RMB currency (due to the growth of offshore RMB centres over the years). Both schemes request an overseas investor to apply for a licence and an investment quota before converting their capital from international currency (including offshore RMB) into onshore Chinese currency to invest. The QFII/RQFII scheme has been widely used by global investors, with Figure 2 showing the number of licence holders and the total granted quota.
Figure 2: No. of Quota Holders and Total Quota Granted for QFII/RQFII
Updated: 28/06/2019; Source: SAFE
CIBM stands for China Interbank Bond Market, where majority (circa 90%) of the bond trading takes place. CIBM Direct (offered to general global investors from 2016) is a scheme that enables global investors to participate in the onshore bond market directly. Investment scope includes treasury bonds, local government bonds, central bank bill, financial bonds, corporate bonds, ABS, as well as a variety of derivative products such as IRS (Interest rate swap), FRA (Forward rate agreement), bond forwards, etc. There is no quota limit, but a global investor does need to register themselves with People’s Bank of China (China’s central bank) and State Administration of Foreign Exchange through a Bond Settlement Agent (usually a local bank) before opening trading account. Now there are 428 global institutions, 76 of which are central banks, participating in the China interbank bond market through CIBM Direct.
“Investing from offshore” Schemes
These schemes give the global investors the opportunity to invest in China onshore market from an offshore position. In this case, the investors can carry out their investment in a familiar international business environment, using international banks, brokerage and other service, and without the need to convert the currency before trading (conversion happens automatically at each transaction, as part of the facilitation of the access scheme). With its unique status as an offshore market from Mainland China but also part of China, HK has played a pivotal role for such schemes. HK-Shanghai/HK-Shenzhen Stock Connect and the Bond Connect programs belong to this category.
- HK-Shanghai/HK-Shenzhen Stock Connect
Launched in 2014 and 2016 respectively, HK-Shanghai Stock Connect and HK-Shenzhen Stock Connect are equity market access programs enabling global investors to invest in stocks on Shanghai Stock Exchange and Shenzhen Stock Exchange by utilising a linkage facility provided by Hong Kong Exchange. Investors maintain their account and service relations in HK. There is a daily limit of total capital flow between HK and Mainland China, but it is high enough and won’t cause any concern to individual institutions in normal circumstance. However, Unlike QFII/ RQFII schemes which allows investors to invest in all listed shares and stock index futures, HK Stock Connect programs provide a much smaller investable universe: As of 25 July 2019, only 580 out of a total of 1,499 stocks listed on the Shanghai Stock Exchange and only 682 out of a total of 2,162 stocks listed on the Shenzhen Stock Exchange are eligible for trading through the HK Stock Connect (Source: Wind Information).
Figure 3: HK Connect Northbound Net Capital flow Data (Billion, CNY):
Updated: 25/07/2019; Source: Wind
Launched in 2017, Bond Connect is a similar mechanism to HK Stock Connect, but gives global investors access to China Interbank Bond Market. The Hong Kong Exchange Central Moneymarkets Unit provide the linkage facilitation while commercial providers Bloomberg and Tradeweb supply the price quote and trading system Through Bond Connect, investors can invest in all cash bond products as with the CIBM Direct scheme, but cannot invest in the derivative products. Currently there are 398 global institutions utilising the Bond Connect channel.
“Getting Onshore” vs “Investing from Offshore”: A Heathy Competition
It is fair to say that “Getting Onshore” schemes and “Investment from Offshore” both have their own merits and drawbacks. Many global investors feel more comfortable with the “Investment from Offshore” schemes since they can carry out investment in a much familiar environment and do not need to worry about capital conversion and repatriation. However, their investable universe is much smaller than through “Getting Onshore” schemes, and transaction cost would be a bit higher due to the extra layer of facility in HK. On the other hand, the ”Getting Onshore” schemes users would be able to invest more broadly into the market and with relatively lower trading cost. However, they wound need to go through a learning curve for onshore business conduct. In general, “Getting Onshore” schemes are slightly more suitable to big institutions who already have a China onshore business presence, while the HK based “Investing from offshore” schemes are a bit more attractive to institutions newer to China market.
It is interesting to see that there has been some healthy competition between the two categories of schemes to attract global capital. For instance, In May 2018, the HK Stock Connect program quadrupled its Northbound (invest into Mainland China) daily cash flow limit from CNY13 billion to CNY 52 billion, with the aim to eliminate any concerns from overseas investor about the possibility of hitting the limit. In January 2019, SAFE announced that the total quota of QFII available was increased from US USD150 billion to USD300 billion, sending a signal to overseas investors and there are more than enough quota to grab.
Shanghai-London Stock Connect: A New Access Model in the making
After a long feasibility study and preparation period, the Shanghai-London Stock Connect program was formally launched on 17th July 2019, with Chinese firm Huatai Securities listing its GDRs on London Stock Exchange. Unlike the HK Stock Connect programs which enable investors to access a new market, the Shanghai-London Stock Connect program enables issuers to “travel” to another market by listing their depository receipts. This is still the early days, but after a while when there are a good number of Chinese companies with DR listing in London, this connect program could provide global investors with very interesting China allocation opportunities: there is a criterion that only large firms listed on Shanghai Stock Exchange (above GBP2.3bn in capitalization) are eligible to list their DRs in London. Companies of this size tend to be industry leaders in China.
Commodity Derivatives Market Access: Early Stage Development
It is worth mentioning that Chinese commodity market is experiencing open-up as well. In 2018, there is a pilot program to open the trading of some selected products to global investors. Each of three regulated commodity futures exchanges in China made one product available: Shanghai Futures Exchange chose its crude oil futures, Dalian Commodities Exchange opted for its iron ore futures, while Zhengzhou Commodities Exchange selected its PTA contracts. This program has been well received by international traders and we expect there will be further and quicker opening in this market.
ATC Initiative will have our next event in Paris on 16th Oct. Do come to join us for more discussion.
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