Capital markets: All roads lead to China
There are numerous channels through which the Chinese capital markets are opening up to foreign investors
- In recent years several channels have been opened to give overseas investors easier access to China’s substantial financial markets
- ‘Getting onshore’ schemes require investors to move their money before investing whereas ‘getting offshore’ schemes allow investors to invest from offshore
- Both sets of schemes have advantages and disadvantages
- The Chinese commodity market is also opening up
As the second-largest economy in the world, China’s economic significance is well recognised. However, foreign capital participation in Chinese capital markets is relatively low despite China ranking high in the size of these markets (second-largest equity market and third-largest bond market). This is largely because of the capital controls still in place. But in recent years there is a clear accelerating trend of the opening up of capital market and a variety of channels have been adopted to facilitate overseas investors to access China equity, bond and other markets.
Figure 1 shows a brief history of opening up of the Chinese capital markets. While some China-savvy investors may argue that there were B-share offerings 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 renminbi holders to access China domestic capital market, followed by Hong Kong (HK) Stock Connect, CIMB-Direct and Bond connect, introduced at a much higher speed, showing an acceleration of capital control relaxation.
Admittedly there are many abbreviations discussed here that may cause confusion. For international institutional investors, in practice, a defining element of a scheme is whether it requires them to move their money onshore before investing (getting onshore) or allows them to invest from an offshore position (investing from offshore). Let us examine the channels along these two lines.
‘Getting onshore’ schemes
These schemes require an international investor to convert its currency into onshore Chinese currency (renminbi), move the capital onshore to a China-regulated bank, use the domestic brokerage service, and invest in Chinese domestic markets much like a domestic player. QFII/RQFII and CIMB Direct belong to this category.
● QFII/RQFII. 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 similar to QFII, but it is designed for overseas investors who have offshore renminbi currency (owing to the growth of offshore renminbi centres over the years).
Both schemes require overseas investors to apply for a licence and an investment quota before converting their capital from international currency (including offshore renminbi) 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.
● CIBM Direct. CIBM stands for China Interbank Bond Market, where the majority (about 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, asset-backed securities (ABS), as well as a variety of derivative products such as interest rate swaps, forward rate agreements, bond forwards, and so on.
There is no quota limit, but a global investor does need to register with the People’s Bank of China (China’s central bank) and the State Administration of Foreign Exchange through a bond settlement agent (usually a local bank) before opening a trading account. There are now 428 global institutions, 76 of which are central banks, participating in the China interbank bond market through CIBM Direct.
These schemes give the global investors the opportunity to invest in China onshore markets 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 services, 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, Hong Kong has played a pivotal role for such schemes. HK-Shanghai/HK-Shenzhen Stock Connect and the Bond Connect programmes belong to this category.
“People usually count the 2002 Qualified Foreign Institutional Investor scheme as the first meaningful access channel for global investors”
● 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 programmes 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 Hong Kong. There is a daily limit of total capital flow between Hong Kong and mainland China, but it is high enough and will not cause any concern to individual institutions in normal circumstances.
However, Unlike QFII/RQFII schemes which allow investors to invest in all listed shares and stock index futures, HK Stock Connect programmes 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, according to Wind Information.
● Bond Connect: 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 provides 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.
Onshore versus offshore
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 more 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 costs would be a bit higher owing to the extra layer of facility in Hong Kong.
On the other hand, the getting onshore schemes users would be able to invest more broadly into the market and with relatively lower trading costs. However, they would need to go through a learning curve for onshore business conduct.
In general, getting onshore schemes are slightly more suitable for big institutions that already have a China onshore business presence, while the Hong Kong-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 programme quadrupled its northbound (investment into mainland China) daily cash flow limit from RMB13bn to RMB52bn (€1.7bn to €6.7bn), with the aim of eliminating concerns from overseas investors about the possibility of hitting the limit.
In January 2019, SAFE announced that the total quota of QFII available was increased from $150bn to $300bn (€135bn to €225bn), sending a signal to overseas investors that there is more than enough quota available.
After a long feasibility study and preparation period, the Shanghai-London Stock Connect programme was formally launched in 17 July, with Chinese firm Huatai Securities listing its global depository receipts (GDRs) on London Stock Exchange. Unlike the Hong Kong Stock Connect programmes which enable investors to access a new market, the Shanghai-London Stock Connect programme enables issuers to ‘travel’ to another market by listing their depository receipts (DRs).
This is still the early days but in time, when there are a good number of Chinese companies with DR listing in London, this connect programme could provide global investors with very interesting China allocation opportunities: there is a criterion that only large firms listed on Shanghai Stock Exchange – above £2.3bn (€2.6bn) in capitalisation – are eligible to list their DRs in London. Companies of this size tend to be industry leaders in China.
It is worth mentioning that the Chinese commodity market is opening up as well. In 2018, there was a pilot programme to open the trading of some selected products to global investors. Each of three regulated commodity futures exchanges in China made one product available: the Shanghai Futures Exchange chose its crude oil futures, Dalian Commodities Exchange opted for its iron ore futures, while Zhengzhou Commodities Exchange selected its purified terephthalic acid (PTA) contracts. This programme has been well received by international traders and we expect there will be further and quicker opening in this market.
Sun Wei is the founder of the Allocate to China (ATC) Initiative, a research-based communication and solution platform bringing together global investors, asset managers and other stakeholders