One of the main challenges facing foreign investors with an interest in China is a complex and constantly evolving regulatory system. Not only are there multiple channels that provide access to the country’s onshore bond and equity markets, its currency is subject to different trading regimes depending on whether the funds are held onshore of offshore. Keeping up with changes in connectivity, market infrastructure, and FX trading is therefore essential for successful investing in the world’s second largest economy.
The most significant developments in China’s market structure were the subject of a webinar that was part of HSBC’s recent China Conference, which allowed a series of expert speakers to highlight the changes related to their subject area.
QFII – Smoother access going forward
One of the most recent developments was a major reform to the Qualified Foreign Institutional Investor programme (known as QFII), one of the oldest channels for foreigners to access China’s onshore securities. In May 2020, the regulator introduced a new ruling to improve the operation of the scheme – most notably, it simplified the administrative requirements associated with the repatriation of funds. It also removed the requirement for investors to apply for an investment quota from State Administration of Foreign Exchange (SAFE).
This is a significant boost to QFII, as it removes the longstanding cap on how much a foreign institution can invest via the scheme, while at the same time answering longstanding concerns related to the ease of taking money out of China. In recent years, QFII has become part of a broader range of channels into onshore China, as the Bond Connect and Stock Connect programmes provide alternative channel to the country’s domestic bonds and equities.
The changes to QFII will likely make investors reconsider its viability as a route into China, said Patrick Wong, Head of China Business Development and Client Management at HSBC Securities Services. Both QFII and the Connect programmes will continue to co-exist and develop in parallel, he said, with each scheme appropriate for different investors according to their individual needs.
“But looking to the longer term, foreign investors will be able to invest directly into the market as China’s market infrastructure gradually aligns with international standards,” said Mr. Wong. “We have a view that over the long run, regulators would prefer investors to go direct.”
Index inclusion – making progress
China’s inclusion into a range of global indices is another major trend that contributes to the country’s integration into the international financial system. The process is already underway, with the country accounting for a growing weight in several widely followed indices that investors use to benchmark their performance.
In the equity space for example, China accounted for approximately 33 per cent of the MSCI Emerging Markets Index in December 2019, up from 28 per cent in June 20171. In fixed income, the Bloomberg Barclays last year started a phased introduction of RMB-denominated government and policy bank securities into its Global Aggregate Index, which will result in a 6 per cent weighting when the process is complete later this year2.
“Will index inclusion end here? The answer is ‘no’,” said Mr. Wong. Although China’s increased representation in international indices is only a matter of time, he said that further inclusion is dependent on the introduction of new reforms.
For equities, he said that these will likely take the form of increased hedging options, especially in the futures market. He also said that liquidity on the offshore renminbi (CNH) could become an issue. Previous rounds of inclusion have not put pressure on the availability of CNH for foreign investors, but it might be sustainable as the weighting of Chinese equities is increased in the future.
Liquidity is also a factor for further inclusion of bonds on fixed income indices, especially for those investors trading on the China Interbank Market. Mr. Wong said that liquidity tends to be good during the initial offering stage but that dies away in the following months. This can put investors tracking an index in a difficult position, he said. In response to this, the regulator is using existing bonds for reissuance rather than issue new bonds, which helps for the liquidity of those bonds included in the index.
Currency considerations – accessing the CNY
Foreign investors are more inclined than before to execute their China trades in CNY rather than CNH. In terms of FX flows, HSBC clients dealing with the bank’s onshore entities, there has been a 40 per cent increase in CNY volumes in the first quarter of this year compared to the same period of last year, said Robert Winmill, Head of Institutional FX Sales, Hong Kong, and Head of FX Solutions, Asia Pacific, HSBC. And for clients facing HSBC’s offshore businesses there have been a 400 per cent increase over the same period.
The move towards CNY is partly due the difference in the spot market rates between the onshore and offshore currency, which is often around 50 basis points and can exceed 100 basis points. Such a large discrepancy can be a factor for passive funds to move to CNY execution because their benchmark is typically denominated in CNY, so if they hedge in CNH the different rates can lead to a tracking error. Issues like this can be resolved by the growing range of trading options available to foreign investors.
These include Notice 159, announced by the People’s Bank of China in December 2018, which allows offshore participating bank entities to offer onshore deliverable CNY to offshore investors. Another option for investor is a new rule introduced by SAFE in January 2020 that allows investors to execute with CNY with up to three FX banks in China, thus enabling them to participate in the interbank FX market via a prime broker of as a member of China Foreign Exchange Trading System (CFETS)
“We expect to see a continued increase usage of CNY by foreign investors, and we expect this trend to be driven by the ongoing relaxation of FX market regulations and the continued deepening of CNY liquidity compared to CNH,” said Mr Winmill.