QDII funds get bite of China's A-shares
Changes to China's Qualified Domestic Institutional Investor (QDII) scheme announced at the end of the year appear to tug in opposite directions a project initially set up to allow Chinese people to invest in overseas securities through authorized financial institutions.
One change to the scheme, which offers an overseas outlet for domestic savings while the country's currency, the yuan, remains not fully convertible, makes Britain the second overseas market after Hong Kong in which Chinese banks can invest QDII funds.
The US markets are expected to be next in line for opening to QDII funds. Li Fuan, head of the China Banking Regulatory
Commission’s innovation supervision coordination department, last month said agreement was reached during the two-day third Strategic Economic Dialogue with the US in December to allow Chinese banks to invest clients’ money in US markets.
According to the Shenzhen Daily, Li didn't give a specific timetable for implementation of the QDII expansion, saying only that it would happen "very quickly".
The expansion will help financial institutions to diversify risks and was broadly welcomed by the domestic media and economists. A second notable change in QDII rules had a more mixed reception, with some economists and analysts describing it as "ridiculous" and "unreasonable".
On December 12, China's fund management firms, securities brokerages and banks - the main implementers of QDII funds - received a "gauge document" from the China Securities Regulatory Commission (CSRC) stating that QDII funds can in future be invested in mainland as well as overseas markets. That means the funds can be used to trade in yuan-denominated A shares listed in Shanghai and Shenzhen.
The change was seen by some as another move by the regulator to prop up the QDII scheme, which has failed to develop as quickly as initially intended. Others saw it as a reaction to faltering local markets, which after raising concern of overheating early in the year as they continued the strong gains of 2006, have declined by about 20% since November, threatening the holdings of millions of retail investors who have little other outlets to increase their savings.
The QDII scheme, launched in April 2006, is at present the only legitimate channel for mainland Chinese investors to buy overseas equities. Under the program, Chinese banks, fund managers and insurers are allowed to invest in securities, government and corporate bonds and fixed-income instruments on overseas markets within certain quotas.
One purpose behind the scheme, which allows individuals to convert yuan funds freely for capital investment overseas, was that it would help trim expansion of the country's growing foreign exchange reserves, curb excessive liquidity in domestic markets and reduce pressure on the Chinese currency to appreciate. It is was also part of moves to liberalize the yuan on the capital account.
China several years ago liberated the yuan in the current account, which roughly speaking deals with daily flows of money. It only partly opened the capital account, through the QDII and Qualified Foreign Institutional Investor schemes, by which overseas funds can enter the mainland market. Only when the yuan is free on the capital account will it be a fully convertible currency.
"Easing foreign exchange reserve pressures is part of the aim of the introduction and expansion of the QDII scheme, but more important is further liberalizing the yuan on the capital account," Guo Song, director of the capital accounts department at the State Administration of Foreign Exchanges (SAFE), said at a forum in Beijing in November.
By the end of last March, just before the QDII scheme was launched on April 18, China's foreign-exchange reserves, propelled by a huge trade surplus and foreign direct investment, had reached US$875.1 billion, up 32.8% year-on-year. This amount helped to drive up liquidity in domestic markets and intensified pressure on the government to allow a faster appreciation of the yuan against the US dollar.
The QDII scheme was seen as a way of cooling local stock markets by offering a new channel for the country's more than 100 million stock investors, who have little more than 1,000-plus companies listed on the Shanghai and Shenzhen stock exchanges to put their money into. Local and foreign-currency savings had risen to 31.8 trillion yuan (US$4.4 trillion) by the end of March, of which around half was from households, according to the figures provided by the People's Bank of China.
Even so, funds continued to pour into the local stock markets, seen as offering better returns than overseas outlets even before the subprime mortgage crisis in the US had started to be felt around the world. China's CSI 300 Index, a measure of stocks on the Shanghai and Shenzhen exchanges, rose about 160% last year. That compares with a maximum gain of about 60% in the Hong Kong benchmark Hang Seng Index.
Some economists said the strength of the A-share market, with the better returns it offered, was one reason behind the change to allow QDII funds to invest at home even though the scheme was intended to ease excessive domestic liquidity.
"QDII should abide by the following rule: capital flows to where profits and returns are high. That's why the funds can be invested 100% locally or abroad," said Wang Lianzhou, a retired securities law professor who led the QDII Drafting Committee.
The QDII "should be built on sufficient conditions and a solid foundation", he said. "Its investment performance has not been satisfying ... So the move by the CSRC is affirmative in correcting the problem once it was found."
As of December 31, the per-share net asset value of the first batch of QDII products had all fallen below one yuan, translating into a paper loss for subscribers as the funds were sold at one yuan a unit. For example, Huaxia Global Selected Stock Fund reported a per-unit net asset value of 0.893 yuan, Southern Global Selected Stock Fund reported a per-unit net asset value of 0.937 yuan and Harvest Overseas Fund reported 0.897 yuan.
Investment in mainland markets has also been made more attractive by the appreciation of the yuan since the government scrapped the currency's direct link to the US dollar in July 2005. The yuan strengthened about 7% last year and forward contracts indicate it may gain a further 9% against the US currency this year. Even so, the domestic stock market has declined by about 20 per cent since November, as government measures such as increased interest rates to cool the economy have started to bite.
By that light, the gauge document was also "a responsible move for regaining investors' interest", Wang said.
Zhu Geyu, director of marketing at China International Fund Management Company, one of the fund managers approved to invest in overseas stocks, said it was wrong to say permission to invest in the domestic market was granted due to the temporary loss in value of QDII products.
"Every policy launch is considered from the angle of long-term development by a regulatory authority, which would not change a policy solely because of short-term volatility or temporary drop of the products' initial-offer prices," he said.
He said the gauge document confirmed institutional investors' right to choose where to put funds and was in line with the QDII products' concept of global investment.
The QDII scheme was introduced with an initial total quota of $14.2 billion, and 17 banks and funds were awarded quotas to invest overseas. Only $4 billion was remitted as of March 2007, due to restrictions imposed by the authorities on the design of QDII products, the appreciation of the yuan and the greater returns to be gained from investing in the domestic stock market.
Beijing later eased regulations to include brokerage houses and other institutions to invest through QDII, so that the total investment quota had reached $42.17 billion as of the end of September, of which $16.1 billion was granted to banks, $19.5 billion to fund management companies and $6.57 billion to insurers, according to the 21st Century Economic Herald.
Among institutions granted QDII quota are 20 insurers including China Life Insurance Company, Ping An Insurance (Group) Company, PICC Property and Casualty Company and China Reinsurance Company, the China Insurance Regulatory Commission said at the end of November.
The expansion of the QDII to mainland stocks was criticized by Yi Xianrong, a researcher with the Institute of Finance and Banking under the Chinese Academy of Social Sciences (CASS). The scheme, as implied by its name, was for investing in overseas markets, he said
"Allowing QDII to invest in the A-share market will only mean it will miss its goals of reducing excess liquidity and foreign exchange reserves. Meanwhile, there are many A-share funds in China for those who want to buy domestic shares, so it's ridiculous for the institutional investors to buy A shares after trying so hard to get the QDII quotas," he said.
"The possible high returns from the soaring A-share market should not be a reason for the new change as each market has ups and downs."
Issac Meng, a Beijing-based economist at BNP Paribas Securities, echoed Yi's views, saying it was ridiculous for QDII funds to invest in A-shares as this would cause operational and regulatory issues. "The change might pose operational issues such as how the awarded quotas should be divided into overseas or A-share markets, or if the institutions with QDII quotas need to ask for extra quotas for the A-share market," he said.
Industry players expect the amount of QDII funds that will flow into A-shares to be less than the amount going overseas. Zhu, from China International Fund Managemement, said funds could be used for combinations such as "China and India" investments that would include A shares.
Hao Kang, fund manager of the China Opportunity Global Stock Fund at ICBC Credit Suisse, argued that the change extended the institutional investors' "right to choose" in investing in overseas markets, which in turn would enhance their profit opportunities at different stock markets.
"However, given that time for China to fully open its existing capital market to the world is not ripe, even if QDII funds will be allowed to invest in the A-share market, the proportion of funds under my management that will be allocated to the A-share market will be limited to about 10%. The fund will focus on overseas markets," Hao said.
Wang Jingxin, an analyst at Guosen Securities, expected the proportion of QDII funds that will be allocated to the A-share market to be limited in the short term. "I don't think much of the share of funds will be invested in the A share market. Otherwise, the QDII funds will turn out to be A-share funds," he said.
An official at China International Capital Corp (CICC), who asked not to be named, said "priority will be given to H shares, though the QDII quotas will be allowed to invest in A-shares and other overseas markets, as we know the Hong Kong stock market better". H shares refers to mainland-incorporated companies listed in Hong Kong.
CICC, in which Morgan Stanley holds a 34% stake, said on December 17 that it had received a $5 billion quota for its QDII fund and expected to launch a product before or after the Chinese New Year in early February.
Yi, from CASS, said that despite the increasing number of markets in which the QDII funds can be invested, H shares will benefit most as the mainland institutions have a better understanding of the Hong Kong stock market and the mainland companies listed there.
Jun Ma, chief economist at Deutsche Bank, expected that between $50 billion and $70 billion will flow to Hong Kong from the mainland via the QDII program in the next six to 12 months.