Pension fund managers from across the globe are seeking access to China, the world’s second largest economy, to profit from the country’s continued economic growth. Western markets remain volatile and unsettled, while China’s prospects appear increasingly attractive to investors seeking to diversify away from reliance on developed markets, but instead to identify emerging market winners.

 AustralianSuper has received much press attention this year for its increasing focus on Asia, including the establishment of its first overseas office in Beijing. Stephen Joske, the new senior manager for Asia, is also AustralianSuper’s first investment executive outside Australia. AustralianSuper’s Chief Investment Officer, Mark Delaney, recently said the super is ex¬pected to boost its exposure to Asian markets to about $7bn by 2016. Joske, a Mandarin speaker and former federal treasury adviser, will oversee the fund’s strategy for increasing investments in the region. He confirms that AustralianSuper’s exposure to China is expected to grow very quickly, and that the fund may apply for a QFII licence, although its total allocation to the country would ideally be higher than the amount allowed under a QFII quota.

 The QFII route is likely to be pursued by a growing number of overseas pension funds looking to invest directly in China’s markets. This year, the China Securities Regulatory Commission for the first time awarded QFII quotas to pension funds. International investors approved by CSRC in March included Canada’s Pension Plan Investment Board and Ontario Teachers’ Pension Plan Board, Stichting Pensioenfonds voor Huisartsen, based in the Netherlands, and the Kuwait Investment Authority.

 Many smaller funds around the world are watching these developments closely.  For example, RPMI Railpen Investments, manager of the UK’s £17bn ($27bn) Railway Pensions Scheme, was reported in August to be considering applying for a QFII licence to invest in Chinese equities and bonds. In an interview, CIO of RPMI Railpen, Keith Shepherd, said: “China is massively influential and will continue to be an important source of returns for us.” Previously, the fund has invested onshore in China via other institutions’ quotas and in H-shares, listed in Hong Kong. 

 Leading institutional investors in Asian are also showing keen interest in participating in the QFII programme. Earlier this year, Bank of Thailand and Bank of Korea were allocated the largest QFII quotas of $300m each. Korea’s National Pension Service is thought to be trying to expand its $100m allocation, while the Hong Kong Monetary Authority has just seen its quota increased from $300m to $1bn. Another new QFII qualifier is Hong Kong’s Hospital Authority Provident Fund Scheme, which represents nearly 35,000 members from Hong Kong’s health professions.  According to Heman Wong, executive director of the scheme, the move came in response to overwhelming demand from members for greater exposure to the mainland.

 Japan’s Government Pension Investment Fund (GPIF), the largest pension fund in the world, does not currently have QFII status, but has announced plans to invest over $1bn this year in the stock markets of emerging economies including China. Takahiro Mitani, president of the fund, said that investment size is likely to increase as the fund gains experience. GPIF is also thought to be considering increasing its investment in Sumitomo Mitsui Trust Bank, which is already a qualified QFII participant.

 Temasek Holdings, a Singapore government investment vehicle, took this approach of using subsidiary companies to gain access to the mainland. Temasek Fullerton Alpha Investments was initially awarded a QFII licence in 2005. This year, Temasek has applied for a huge quota increase that would take its total allocation above $1bn.

 This tremendous global investor interest in China is hardly surprising. The PRC has just completed its third decade of sustained economic growth at rates exceeding 9% per year.  As Christine Lagarde, Managing Director of the International Monetary Fund, said in Beijing earlier this year, “My desire to be here reflects just how important China has become for the global economy.” China is well on track to overtake the US as the largest global economy in the next few years, and - while growth may slow down over the next decade - China’s progress will continue to outpace much of the developed world.

 But let’s not forget that this economic achievement has been realised at considerable environmental and social cost. If China cannot reduce the environmental degradation that is increasingly blighting the country and tackle the negative impacts on many of its people, the long term sustainability of China’s “economic miracle” risks becoming steadily undermined.

 Notwithstanding meaningful achievements during the 11th Five Year Plan period - including an improvement in energy intensity, better treatment of municipal and waste water, reduction in sulphur dioxide emissions and considerable capacity increase in renewable energy generation - the PRC continues to face significant environmental challenges.

 Fewer than 1% of the 500 largest cities in the country meet the air quality standards recommended by the World Health Organization, and seven of these cities are ranked among the 10 most polluted in the world. Water supply is becoming a chronic problem, as changing weather patterns worsen shortages caused by pollution and poor infrastructure. By 2030, demand could exceed supply by as much as 200 billion cubic meters.  Solid waste management, especially industrial waste, is a growing challenge.

 One third of the total land area in China is prone to desertification, and large scale land degradation is caused by water erosion. Deforestation and other habitat destruction, an inevitable side effect of urbanisation and industrial development, create serious threats to the country’s biodiversity. All these problems could be exacerbated by climate change effects.

 These conditions are already imposing significant economic costs on China. According to the Chinese Academy of Sciences, the total annual cost of resource and environmental degradation (including resource consumption) was equal to 13.5% of GDP in 2005. 

 As global investors seek to benefit from China’s tremendous growth, these realities must not be overlooked. Such extreme externalities could present great risks to investment returns, reflected perhaps in terms of the future costs of securing resources and doing business in China, or potentially by the imposition of draconian regulations as the government aggressively seeks to change the country’s development model entirely.

Alexandra Boakes Tracy is Chairman of Association for Sustainable & Responsible Investment in Asia (ASrIA)