Recent press articles in Australia have spoken of “waves of investment” flowing into Australia from China and from Australia into China. The expression “waves of investment” can conjure optimism, especially among those who are well placed to ride such waves to greater financial success. However, “tidal waves of investment” creates an entirely different feeling. It is difficult to foresee the full extent of the rising swell, but Australia should prepare to be a big wave rider as its investment relationship with China quickly gathers momentum.
Australia-China Relations Institute Deputy Director, Professor James Laurenceson, recently reported that new data from the Australian Bureau of Statistics (ABS) shows that not only is China our most important trade partner, but it is on the verge of becoming our most important investment partner. According to the ABS, in 2013 and 2014, two-way investment with China surged by $71.3 billion. This was not only the result of a substantial increase in Chinese investment in Australia, but also because of a significant jump in Australian investment in China.
China’s great sea wall
Mainland China has for years protected itself from the nasty consequences of financial tsunamis by a great sea wall, which has to a large extent separated its capital markets from the rest of the world. This wall has many parts, but the foundation stones have been mainland China’s closed capital account and its strict foreign currency exchange controls. So, companies, banks and individuals cannot move money in or out of mainland China, except in accordance with strict rules.
Restrictions facing mainland China’s institutional investors
Mainland Chinese institutional investors (fund management companies, commercial banks, insurance companies, securities houses, trust companies) have been – until recent developments – limited to investing outside of mainland China only through the channel of China’s Qualified Domestic Institutional Investor (QDII) scheme. The QDII scheme permits outbound investment by mainland Chinese investors through the above-mentioned designated qualified financial institutions. It requires the said mainland Chinese institutional investors to obtain an approval from the relevant mainland Chinese banking, securities or insurance regulator and a foreign exchange quota from mainland China’s foreign exchange regulator before the institutional investor can invest in qualified offshore financial products.
Restrictions facing mainland China’s individual investors
Since 2006, mainland Chinese individuals have been allowed to invest abroad through funds that are licensed under the QDII scheme. Even given that mainland Chinese regulators have been quite supportive of QDII applications and generous with quota – especially during times of relative economic strength (to help remove liquidity from the economy) - for a nation with a household savings pool of about $US8 trillion, the existing $US88 billion QDII quota is small.
Outside of the QDII scheme, mainland Chinese individuals have largely been limited to buying the equivalent of $US50,000 in foreign currency for overseas travel, shopping and study each year, unless they have been able to offshore their monies through unofficial channels.
Restrictions facing foreign institutional investors
For more than the past 10 years, foreign institutional investors have only been able to purchase mainland Chinese A-shares and other qualified Renminbi-denominated securities through China’s Qualified Foreign Institutional Investor (QFII) program. The program requires qualified foreign institutional investors to obtain an approval from mainland China’s securities regulator to buy into mainland China’s securities under a given quota issued by mainland China’s foreign exchange regulator. The program imposes three-month lock-up periods and repatriation restrictions, preventing qualified foreign investors from making frequent transactions. As at the end of March 2015, a total $US72.1 billion of QFII quotas had been assigned, representing just over 1% of China’s $US6.3 trillion stock market. A separate Renminbi Qualified Foreign Institutional Investor (RQFII) program provides a channel for Chinese yuan held outside of mainland China to be invested in mainland China’s securities.
Restrictions facing foreign individual investors
Foreign individual investors have been limited to investing in mainland Chinese A-shares and other qualified Renminbi-denominated securities through products offered by QFII licence holders.
Harbour in the tempest
Put simply, as a consequence of these controls, foreign investors have limited exposure to mainland China’s stocks and bonds, and mainland Chinese investors are generally restricted to investing in domestic assets. Many commentators have attributed China’s ability to endure the Asian financial crisis of the late 1990s and the global financial crisis of the late 2000s to China’s capital and foreign exchange controls. More recently, experts have said that such controls have saved China from the turmoil that hit other emerging markets at the start of this year. But things are changing.
Time for reforms
In March 2015, Chinese Premier Li Keqiang pledged to press on with “wrist slashing” reforms, while mainland China’s central bank governor has promised to further open financial borders in the quest to gain reserve status for the nation’s currency. Later this year the International Monetary Fund’s has its once-in-five-year review of whether to include the Chinese yuan in its Special Drawing Rights (SDRs) international foreign exchange reserve assets. And all the while the voices in mainland China seeking a more open, market-driven economy grow louder.
Loosening the controls will promote investment flows in and out of mainland China, and offer mainland Chinese savers new options beyond the extraordinarily expensive property market and shadow banking sector. However, the risk is that it leads to unwanted swings in asset prices as speculative capital floods in and out of mainland China.
The Chinese government’s easy-does-it approach to opening valves in its capital market’s sea wall is picking up unprecedented speed.
Developments in Qualified Domestic Limited Partner Program (QDLP)
In recent days, it has been reported that mainland China’s fledgling Qualified Domestic Limited Partner Program will be expanded to allow select international fund managers (including some of the world’s largest asset managers and hedge funds) to raise billions of dollars from Chinese investors.
Mutual recognition of funds
On 22 May 2015, mainland China’s securities regulator announced that a long-awaited scheme to allow funds domiciled in Hong Kong and mainland China to be sold in each others’ market will be launched on 1 July 2015, in a move to facilitate cross-border investment. It has been reported that the initial quota for mutual fund recognition will be 300 billion yuan ($63.2 billion) in each direction. Funds will need to have been established for at least one year and, based on that criteria, around 100 Hong Kong-based and 850 mainland Chinese funds will qualify.
Pilot of Qualified Domestic Individual Investor program (QDII2)
On 18 May 2015, China’s State Council issued a notice regarding reform of China’s economic system. Among other things, the notice stated that the central government will soon launch a pilot project in respect of QDII2, under which mainland Chinese individual investors will be allowed to invest directly in financial products outside of mainland China. To date, offerors of certain foreign financial products have had to either “distribute” such products through existing QDII licence holders or ensure that any invitation to offer, offer, acceptance and sales documentation in respect of such products is: (i) sent to mainland Chinese individual investors with funds offshore to mainland China; (ii) sent to an offshore address outside of mainland China; and (iii) is signed offshore to mainland China. Given the obstacles, most Chinese individual investors have preferred to invest in mainland China’s burgeoning property market.
It has been reported that the new QDII2 pilot scheme will be launched in six cities: Shanghai, Tianjin, Chongqing, Wuhan, Shenzhen and Wenzhou. It will potentially unleash billions of dollars in mainland Chinese savings on global stock and bond markets. Individuals with at least 1 million yuan ($210,000) of financial assets can apply to join.
Expansion of QFII investment quota
In March 2015, it was reported that mainland China’s securities regulator had removed the $US1 billion investment quota (which had been in place since 2009) for overseas fund management firms that want to invest in mainland China under the QFII regime.
Launch of Qualified Domestic Investment Enterprise (QDIE) scheme
This followed the launch of the QDIE scheme in February 2015, which enables mainland asset managers registered in the city of Shenzhen to invest in overseas financial instruments. The eight domestic managers that have signed up, including China Southern Asset Management, China Merchants Fund, Great Wall Securities and China Credit Trust, can now raise up to $US1 billion between them from mainland Chinese investors for investment in overseas financial instruments.
Shanghai-Hong Kong stock connect program
These latest steps to deregulate China’s capital markets came after the launch of the Shanghai-Hong Kong stock connect last November. In terms of outbound investment by mainland Chinese individual investors, the Shanghai-Hong Kong stock connect program is narrower in scope than the proposed QDII2 pilot scheme in that it is focused on guiding mainland Chinese investors into Hong Kong-listed stocks related to mainland China and offers little opportunity for risk diversification, while keeping a tight rein on the risk of capital flight.
Before the program was introduced, individual investors, in Hong Kong or from overseas, could only participate indirectly in mainland China’s securities markets through certain investment products such as QFII funds, RQFII funds and RQFII A-Share Exchange Traded Funds. Now that the program has been launched, the northbound trading link of the program allows Hong Kong and foreign investors to invest directly in eligible A-shares listed on the Shanghai Stock Exchange through Hong Kong brokerage accounts. Further, the southbound trading link of the program enables mainland Chinese investors (including individual investors) to trade eligible Hong Kong-listed stocks directly though local brokerage accounts. The Shenzhen Stock Exchange is expected to launch a similar program this year.
Expansion of China’s debt capital market
In other recently developments, mainland China’s central bank has reportedly commented that rules will be relaxed for mainland Chinese companies to sell bonds and stocks in overseas markets, and for overseas companies to sell stocks or bonds in mainland Chinese markets. It is understood that fundraising both ways will be in Chinese yuan or US dollars. Mainland China has plenty of incentives to grow its debt capital market. As experts have explained, a well-developed bond market would provide long-term investments with fixed returns to an ageing population, give the growing middle class an additional investment vehicle with which to diversify their portfolio, and create a less costly but more efficient channel of funding for mainland Chinese companies.
Australia’s response to China’s changing place in the financial world
China is the world’s largest trading nation and, according to many experts, it will soon be its largest economy. In 2013, its share of global GDP as well as global trade was 12%, but it holds a much smaller percentage of global holdings of overseas assets and liabilities. Mainland China had an estimated 145 trillion yuan ($30.5 trillion) in total investable assets as of the end of 2013, which is expected to grow to 260 trillion yuan ($54.5 trillion) by 2020. As mainland China gradually removes chunks of the sea wall separating its capital markets from the rest of the world, we will see much greater inflows and outflows of investment capital. Australia’s financial institutions, regulators and investors will need to be ready for the surge.
Author: Carl Hinze
Ian Robertson, Partner
T: +61 2 8083 0401
Carl Hinze, Partner
T: +61 7 3135 0630
The information in this publication is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavour to provide accurate and timely information, we do not guarantee that the information in this newsletter is accurate at the date it is received or that it will continue to be accurate in the future.