China refines QFII and RQFII to broaden appeal
Expansion and development of the QFII and RQFII schemes was a major topic for foreign investors in China throughout 2012. IPA caught up with investors, custodians and lawyers who work on the scheme to assess their reactions to developments last year, prospects for 2013 and the efforts of the Chinese regulators to make the schemes more attractive to long-term investors.
Despite uncertainty surrounding the leadership transition and new government policies, last year was marked by a steady stream of announcements that increased the size and scope of the QFII and RQFII universes, while strong market performance since December reinvigorated investor appetite for China exposure.
However, while quota expansions are welcome, the greater challenge for Chinese regulators lies in structural reforms to increase the integrity and transparency of onshore markets. Here, despite positive signals, reforms may take years to implement and involve radical changes to both regulatory architecture and the wider political economy.
2012 – A year of quota expansion In the year to 20 November, China Securities Regulatory Commission approved $11.9bn of QFII quota for 64 institutions, bringing total quota to $33.6bn and total participants to 199. The authorities abolished the upper the $1bn upper quota threshold for SWFs and governmental investment entities. As such, 2012 marked by far the largest annual expansion of QFII since the scheme’s inception in 2003.
The regulators also expanded the RQFII quota from $20bn to $50bn in July, and have indicated it could be further increased to $200bn if demand dictates. Further out, officials have suggested that quotas for both schemes could be scrapped entirely once China’s market conditions and capital account liberalisation permit it.
Kenneth Ho, Deputy Head of Investment Solution Group at Bank Julius Baer in Singapore, believes that the trend of expansion will continue. “We believe that the regulators will continue to expand at the current pace, as their goal of increasing the QFII quota is to stabilise the markets with long term investors which also include pension funds. With the CSI 300 underperforming since 2009, we believe that the government is making a positive step to restore domestic market confidence.”
Other market participants were also hopeful of further expansion of the scheme, however this will unfold within the wider context of China’s economic reforms and capital account liberalisation. Chi Lo, Senior Strategist, Greater China at BNP Paribas, sees the quota expansion within the broader framework of China’s financial market development.
“The authorities want to avoid any potential shocks from big-bang liberalisation,” says Lo. “The Chinese government will continue to keep control, but will continue to expand the various quotas for portfolio flow, including QFII. RQFII, QDII and other types in the coming years.”
In the latest example of the gradual approach, SAFE announced in early January that two RQFII bond funds, E-Fund RMB Fixed-Income Fund and China AMC RMB Enhanced Fund has each been granted an additional RMB800m ($128m). Following on from RQFII ETF expansion in 2012, this is the first time a fixed-income product quota has been enlarged by the regulator.
Broadening the investable universe Quota expansion can be seen as just one of a range of measures taken by the authorities to attract foreign investment and restore confidence after a torrid three years for mainland markets. These include simplifying the back-office functions for QFII participants through a streamlined approval process and weekly rather than monthly capital repatriation, thereby facilitating better liquidity management.
While these structures are still some way from being fully mature, they reflect the authorities’ willingness to take account of investor demands and concerns, according to Andrew Smith-Plenderleith, Head of Global Custody Product Asia Pacific at J.P. Morgan. “With the changes to the qualification thresholds and streamlining of the quota approval process, investors are seeing other managers being successful in their quota application and viewing China as more of a ‘business as usual’ market. As a result, we’re seeing continued interest from global clients, be it for China-specific exposure or as part of a diversified Asia strategy.”
There have also been significant developments in terms of broadening the investable universe for both QFIIs and RQFIIs. QFIIs were granted access to China’s interbank bond markets, while RQFIIs can now allocate 20% of their AUM to A-Shares.
The regulators are pushing ahead with regulations for QFIIs to engage in stock index futures and margin trading, giving participants greater ability to hedge against market risks. “Strategically, the authorities recognize that they need a broader and deeper market, therefore, they are looking at all options,” observes Julius Baer’s Ho.
The gradualist approach explains why many of the reforms announced in 2012 remain provisional or tentative. However, into 2013 we should see greater clarity as well as more concrete measures to make the schemes more user-friendly, suggests J.P. Morgan’s Smith-Plenderleith. “2012 has been a year of expansion for the investable universe with announcements of opening up of the interbank bond market and stock index futures. 2013 will be the year in which these asset classes are tangibly invested in. SAFE’s revisions to the Provision on Foreign Exchange Administration of Domestic Securities Investment by Qualified Foreign Institutional Investors gives foreign investors further clarity on the regulatory process.”
However, while these are encouraging developments, the precise details of the innovations remain unclear and further expansion of the investment options is necessary to fully satisfy the risk and portfolio management requirements of sophisticated foreign institutions. Market participants were reluctant to second guess the regulators’ next steps, but given the relative under-development of mainland markets and the very limited role of foreign capital within them at present – even after the recent expansion, QFII is still just 2% of total A-share capitalisation - it is clear that there is potential for substantial expansion going forward.
“There are various things Beijing can do in terms of next steps, including expanding the QFII and RQFII quotas further, opening up further the interbank bond market for foreign participation, developing derivative products, allowing more issuance of CNH bonds (by both foreign and mainland Chinese companies), allowing intra-company cross-border lending by MNCs and relaxation of the control of foreign investment in PE projects. The list will grow according to the comfort level of the Chinese authorities,” says BNP Paribas’ Lo.
Tax uncertainty Another area of uncertainty relates to the tax structures for QFII participants. China is in the midst of a broad-based fiscal reform as well as securities market restructuring, while differing reports regarding the eventual details of tax structures for QFIIs have circulated in the media.
The uncertainty has been “a source of frustration for QFIIs for a long time,” according to Jenny Sheng, a Partner at Paul Hastings LLP in Beijing. “A clear tax rule will certainly increase the transparency of the QFII regime and eliminate uncertainties faced by foreign investors. In addition, a 10% tax on QFII profits is reasonable because similar levels of tax have been levied in many other countries in the world.”
J.P. Morgan’s Smith-Plenderleith agrees that resolving this uncertainty rather than the rate of tax itself is the main priority for most participants. “Rather than how high or low it will be, investors are seeking certainty on tax structures. Most QFIIs either hold indemnifications from end beneficial owners or are reserving capital while they await clearer policy and the removal of uncertainty.”
Other issues include whether the tax will be applied retrospectively, as well as how it relates to double-taxation agreements between China and the QFII’s home country. Overall, however, the impact should be limited, says BNP Paribas’ Lo “QFII funds’ NAV will be affected upon implementation. That may cause short-term confusion. But I think with many market players already positioned for it, the negative impact, if there is any, will be short-lived.”
Improving the legal landscape Many long-term investors are reluctant to commit to China given the weak institutional and legal environment onshore. However, in keeping with other efforts to assuage these fears, there have also been a number of legal statements from the authorities clearly intended to alter this perception.
“Structural issues have always been part and parcel of investing in the A-share market,” says Julius Baer’s Ho. “This is why investment managers have been very careful with investments in China and ensure that regular company visits and due diligence are performed before making investments.”
Paul Hastings’ Sheng underscores the importance of improving institutional and legal structures in order to reassure risk-averse long term investors. “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 key measures to attract long-term investors. Therefore, the regulators should put more focus on the oversight and punishment of financial fraud and insider trading as well as enforcement of disclosure obligations by listed companies.”
Among the statements released in 2012, April’s Guiding Opinions on Further Deepening Reform of the System for Offering of New Shares from CSRC was among the most significant. The Guiding Opinions focus on information disclosure, pricing control and removal of the lock-up period. They also detail the liabilities of the issuer, sponsor, law firms and other intermediaries. “The reform brought by the CSRC Guiding Opinions is certainly welcomed by foreign investors because it will increase transparency, reduce insider trading and address the problem of overvaluation,” argues Sheng.
In addition to the CSRC Guiding Opinions, the Supreme People’s Court (SPC) issued the Interpretation on Several Issues Concerning the Specific Application of the Law in Handling Criminal Cases of Insider Trading and Leaking of Inside Information (The Interpretation) last March. “The Interpretation provides detailed rules for prosecution and conviction of insider trading crimes and is also a positive step to increase the transparency of China’s capital market,” she adds.
The slow march to a transparent market Despite the constructive newsflow in terms of quota expansion and more investment options for QFIIs over the past 12-months, arguably the greatest challenge for the Chinese authorities is improving the overall integrity and transparency of mainland securities markets.
“Corporate governance and transparency is on the regulator’s list as an integral aspect of focus and continued evolution of the securities law will enhance risk controls and supervision,” says J.P. Morgan’s Smith-Plenderleith. “Dividends are also key for pension funds and standardisation of cash dividend policies will be a significant positive.”
That said, despite clear signs of progress on key issues, as yet there have been few tangible measures to overcome the fundamental concerns regarding China’s political economy, ranging from the lack of independent credit ratings agencies to an opaque judiciary or non-transparent relationships between various stakeholders in the economy.
For BNP Paribas’ Lo, addressing these issues will take time and remains a work in progress. “There is no quick way, no short-cut to achieving transparency and integrity. The key is to keep the momentum going. The fundamental and most important step that Beijing needs to take is to sever the commercial-political ties, which are the key problem to creating rent-seeking and moral hazard.”