Since the turn of the century, China has engaged in a deliberate program to liberalize its capital markets to allow for direct foreign investment. The program started to accelerate in 2014 when Chinese policymakers began an intensive review of foreign investment regulations to allow greater access to the domestic securities markets. One of the primary goals was to increase access to the Chinese investment market by including China A Shares in the MSCI Emerging Markets Index. Inclusion of A Shares in the index would bolster China’s efforts to attract foreign capital and boost the country’s reputation in the eyes of global investors.
Last year, MSCI chose not to include China A Shares in its Emerging Market Index. The index provider cited the 20% monthly repatriation limit for certain investors and the pre-approval requirements imposed by the local Chinese stock exchanges as two of the primary reasons for its decision. However, MSCI did acknowledge that significant progress has been made and confirmed that it will revisit the issue again in June 2017. MSCI also indicated that it is open to an off-cycle review before then.
Although there are some actions for China to take, there is a growing feeling that China’s MSCI inclusion is only a matter of time. Given the increasing likelihood that China A Shares will be included in the MSCI index, global asset managers, particularly passive index managers, should start to understand the two main routes into the Chinese marketplace.
ROUTE 1: QUOTAS
China has established two programs for foreign investors to invest in Mainland China’s financial markets.
- Qualified Foreign Institutional Investor (QFII), established in 2003, allows qualified foreign participants to make investments in Mainland China’s financial markets by remitting foreign currency into China.
- RMB Qualified Foreign Institutional Investor (RQFII), established in 2011, enables participants from 18 approved international domiciles to invest in Mainland China by sourcing Renminbi offshore.
Both programs allow global institutional investors to invest directly into the Mainland capital markets. To participate, investors must receive a QFII or RQFII license from the China Securities Regulatory Commission (CSRC), a process that is documentation heavy and can take several months to complete. Following receipt of a license, a quota must then be allocated by the State Administration of Foreign Exchange (SAFE). While the quota application process has historically taken three to five months to complete, SAFE moved towards allocating quota via the Basic Quota system in 2016, which has decreased the quota allocation process to roughly 20 days. Once the license and quota have been obtained, the investor must then open an account with a custodian in China and seek investor IDs from the depositories. While the approval process initially often took over a year, it can now be completed in as little as six months.
ROUTE 2: STOCK CONNECT
The other way foreign investors can access Mainland China’s financial markets is through the Stock Connect programs. The Shanghai-Hong Kong Stock Connect, established in 2014, enables orders on the Shanghai Stock Exchange (SSE) to be placed through a broker in Hong Kong. Trading of securities is limited to those that meet certain eligibility requirements, which represent roughly 85% of the market capitalization and 68% of the average daily trading value for securities traded on the SSE.
The Shenzhen-Hong Kong Stock Connect, established in December 2016, enables orders on the Shenzhen Stock Exchange (SZSE) to be placed through a broker in Hong Kong. Trading of securities is limited to those that meet certain eligibility requirements, which represents roughly 74% of the market capitalization and 67% of the average daily traded value for securities on the SZSE.
Asset managers looking to invest into Mainland China should be aware of the challenges of operating in the marketplace, which include establishing new broker relationships, adjusting to local market practice, and managing quotas.
Establishing New Broker Relationships
Only locally incorporated brokers can execute orders on the SSE and SZSE and the majority of international brokers do not have local operations. As a result, many investors cannot utilize the services of brokers with which they have existing relationships. Furthermore, the operational complexities of using more than one broker per exchange are challenging and many asset managers choose to use one broker to execute all orders.
Adjusting to Local Market Practice
The T+0 settlement cycle in China presents issues for western asset managers that do not have operations active during the working day in China. Pre-funding of cash must be in place and confirmed by the local custodian to the broker prior to execution of the transaction on the exchange. This requirement is not the norm internationally and therefore requires asset managers to make adjustments in their trading practices.
Quota management is another key concern that has been raised by asset managers. The allocated quota functions as a hard cap on the amount of principal that can be remitted into the market. As such, asset managers must be cognizant of existing and upcoming subscriptions and redemptions to ensure that their investing accounts in China can cope with the overarching shareholders movements.
As China continues to liberalize its markets, the likelihood increases that it will be included in the MSCI index. MSCI’s next official review is scheduled for June, but it has not ruled out making a decision earlier if China makes progress on certain outstanding issues. To ensure they do not get caught flatfooted, it is important that asset managers understand how to access China and the challenges each route presents. This will put asset managers in good stead for when the MSCI inclusion becomes a reality for China A Shares.
This article was originally published in the 2017 Regulatory Field Guide. The guide features insights from a number of our experts on key regulatory developments that will have the greatest impact for asset managers in the year ahead – and beyond. Visit bbh.com/regulatoryfieldguide to explore the guide.