Two decades of Chinese securities markets opening
Beijing’s recent policies are seen to have diverged from market economy practices familiar to foreign investors
Two decades after China opened its securities markets to the world by launching the Qualified Foreign Institutional Investors (QFII) scheme, investing in Chinese securities has never been easier.
The introduction of the QFII scheme in November 2002 was one of China’s first key efforts to liberalise its financial markets. Since then, Beijing has introduced four other schemes that enable foreign investors to access its onshore markets directly.
The Chinese bond and equities markets have now become the second largest in the world after the US. And China is now the world’s second largest economy after the US.
The QFII scheme was conceived as a transitional arrangement to allow international institutional investors who met certain qualifications to directly invest in a permitted range of financial products in China’s capital markets before complete free flow of the nation’s capital accounts. It was Beijing’s delivery on a promise made as a condition of joining the World Trade Organisation in 2001.
Switzerland’s UBS Group and Japan’s Nomura Holdings were the first two approved for a QFII licence in May 2003. Quotas for nine other large investment banks were approved later that year. Nine custodian banks, including three foreign lenders, were also given the green light to provide services to QFII investors.
Foreign investors were subject to strict rules in the early years of the scheme. For example, eligible closed-end funds could only repatriate capital out of China after three years. Each remittance was not allowed to exceed 20% of the total principal, and repatriation of funds could only be done once a month.
Although the initial quotas were only several hundred million US dollars in aggregate, they were goldmines for quota holders to generate profits. Smaller firms had to rent quota from the approved QFIIs at a high premium in order to invest in China’s stock market. Beijing has since increased the quotas and loosened the entry requirements and approval process.
Nine years after launching the scheme, the government introduced another version in late 2011. This one, called the RMB Qualified Foreign Institutional Investor (RQFII), allowed investors to use offshore renminbi to buy stocks in China.
The first batch of approved RQFIIs were all Hong Kong subsidiaries of asset management firms from the Mainland. This was seen as a way for Beijing to help the China-based firms to jumpstart their businesses in Hong Kong. The scheme was later expanded to other fund management firms in the city and to foreign countries with significant pools of offshore RMB deposits, such as France, Singapore and the UK, through a quota for each jurisdiction.
The QFII and the RQFII schemes were the only direct channels for foreign investors to gain access to China’s securities markets up until 2014.
The Connect schemes
The launch of the Stock Connect programme linking the Hong Kong, Shanghai and Shenzhen bourses has redrawn the routes for investing in China’s stock market. The scheme kicked off in November 2014, with the Shenzhen stock exchange added two years later.
The innovative programme enables foreign institutional and retail investors to access the two Chinese bourses from offshore by trading through the Hong Kong exchange. This is a much more familiar platform for them, and they don’t have deal with the legal and regulatory environment in the Mainland. It is a two-way channel as there is also a southbound leg to enable investors in China to access the Hong Kong stock market by trading through the Shanghai and Shenzhen bourses.
Quota restrictions are only imposed at the market level. There are no quotas for individual investors, who can buy and sell on a first-come-first-served basis and work with the settlement rules that they are familiar with. Stock Connect has quickly become the preferred market access routes to China for most foreign investors.
Its success prompted Chinese regulators to open the debt market by launching the China Interbank Bond Market scheme in 2016 under regulatory supervision onshore. This was followed by the Bond Connect scheme a year later under the Hong Kong bourse’s governance offshore.
The Stock Connect programme has seen massive growth in trading volumes since inception. Average northbound daily turnover reached a record 120.1 billion RMB (US$18.6 billion) in 2021, accounting for 5.7% of trading in the Mainland market, according to figures from the Hong Kong bourse. That’s more than 21 times the average daily turnover in 2014.
As of end-2021, foreign investors held 2.76 trillion RMB worth of Chinese securities through the Stock Connect scheme versus just 86.5 billion RMB seven years earlier.
The Hong Kong bourse has sought to make investing through Stock Connect more convenient and reliable by addressing investors’ concerns. It recently launched a pilot programme called HKEx Synapse using DAML smart contracts to help investors better manage their post-trade operations. And exchange-traded funds have been included in the Stock Connect programme since July 2022.
Development of Swap Connect, a new mutual access programme between the Hong Kong and China interbank interest rate swap markets, was also announced in July.
The Bond Connect scheme has also seen healthy growth since it was launched. The average northbound daily turnover was 26.6 billion RMB in 2021, more than 12 times the 2.2 billion RMB average in 2017, its first full year of operation. Investors held 3.8 trillion RMB worth of Chinese bonds through the programme as of end-2021 compared with 1.1 trillion RMB at the end of 2017.
Older schemes revamped
The success of the Connect programmes begs the question as to whether the QFII and RQFII programmes are still relevant.
Chinese regulators made a sweeping revamp of the two schemes in May 2020 by dropping quota restrictions for investors, who are now only required to register with the State Administration of Foreign Exchange through their main custodian. They can choose the currencies and timing of inward remittance based on their own needs. Procedures for income repatriation were significantly simplified.
Restrictions on the number of service intermediaries used were scrapped, supervision of reporting and filing of audit and tax reports were improved, and requirements for data submission were reduced.
Four months later, in September 2020, the regulators announced the merger of the QFII and RQFII schemes, relaxed qualification requirements, streamlined application documents and simplified the reviewing procedure.
The new rules mean that it’s easier for investors with smaller assets under management, such as family offices, commodity firms and hedge funds, to qualify.
The reform also broadened the investment scope to cover more asset classes such as onshore private fund investments, depository receipts, bond repurchase agreements, asset-backed securities, local private funds and private placements. It also opened QFIIs’ access to onshore securities borrowing and lending and the listed derivatives markets.
Allowing QFIIs to invest in onshore private funds was especially welcome news to foreign fund management firms that have set up wholly-owned private fund companies in China because it gives their products the opportunity to gain scale more quickly with allocations from their own group’s QFIIs. Inflows from QFIIs could also potentially help to grow the nascent onshore securities borrowing and lending and listed derivatives markets.
Foreign investors can now tap the onshore markets for depth of liquidity and diversity of products through the revamped QFII scheme while trading through the offshore Connect programmes for convenience and efficiency. This will allow them to implement multi-pronged investment strategies using both onshore and offshore access schemes.
The revamp has led to a sharp jump in QFII applications. Between end-2020 and September 2022, the number of approved QFII investors rose by 174 to a total of 723. That’s a 31.7% increase in 21 months compared to the 10% average annual rise over the six years from the launch of the Stock Connect up to 2020.
What’s ahead?
The global investment environment has taken a drastic downturn in 2022. Rising inflation, surging interest rates, soaring oil and commodity prices, supply chain disruptions, and Russia’s invasion of Ukraine have sparked fears of a global recession.
Apart from global headwinds, there are also unique challenges to investing in the Chinese markets. Beijing’s crackdown on the technology and private tutoring sectors in 2021 had already created a lot of market uncertainty. The multiple heavy-handed lockdowns and controls imposed in 2022 in pursuit of a zero-Covid policy (which was abruptly abandoned in December) as well as a deepening property market crisis is raising concerns about China’s economic health. Meanwhile, China’s relationship with the US is rapidly spiralling downwards with no easing in sight, leading to intensifying geopolitical tensions.
Chinese securities have lost their shine amid these headwinds. According to data from the Washington-based Institute of International Finance, foreign investors pulled out a total $82.8 billion from China’s bonds and equities markets between January and October 2022. It is likely that 2022 will see the first net capital outflow from Chinese securities markets in 20 years.
Foreign investors are now at a crossroads. Beijing’s policies are seen to have increasingly diverged from the market economy practices that foreign investors had become familiar with. There is also a lot of anxiety over how the balance between ideology and economy will play out under China’s agenda of “common prosperity”.
All eyes are now on President Xi Jinping – who was confirmed for an unprecedented third term as the nation’s leader at the Chinese Communist Party’s National Congress in October – to see how he and his new leadership team will steer the country through the challenges and put it on a sustainable path to growth.
*This article was published in Asia Asset Management’s December 2022 magazine titled “At a crossroads”.
