In Depth: Progress and Pitfalls for Foreign Investors in China’s Capital Markets
Foreign investors are flocking to China’s capital markets like never before as the government has implemented opening policies to attract overseas money. Nevertheless, it’s a work in progress and challenges still remain for foreign institutions when it comes to market access and the business environment.
Over the past two and a half years, China has relaxed restrictions and removed barriers to foreign participation in its equities, bond and commodities markets, seeking to encourage capital inflows, integrate its financial system with the rest of the world, and boost demand for the yuan as part of a broader strategy to internationalize the currency. It also wants to attract institutions focused on fundamental long-term investing to counter the influence of short-term trading and speculation that is so prevalent in domestic markets.
The changes were made, and continue to be rolled out, partly in response to pressure from overseas investors and were major factors in decisions by the world’s top equity index providers, MSCI Inc., FTSE Russell and S&P Dow Jones Indices LLC, in 2018 to include Chinese A-shares in their global indexes.
Stock and bond connect programs, which allow foreign investors to trade on the Chinese mainland, have become the biggest avenue for overseas institutions to access the domestic capital market. They now dwarf the two original inbound investment programs — the Qualified Foreign Institutional Investor program (QFII) and the RMB Qualified Foreign Institutional Investor program (RQFII) — which floundered partly because of onerous and complicated regulations and requirements. In the latest move to ease restrictions, announced in May after eight months of preparation, the authorities announced that investment quotas for the QFII and RQFII programs would be scrapped in June.
The value of stocks and bonds held by overseas entities has almost doubled since the end of 2017, data from the People’s Bank of China show. Their holdings stood at 4.2 trillion yuan ($594.6 billion) at the end of March 2020, up from 2.4 trillion yuan at the end of 2017.
Even so, foreign participation in China’s capital markets is still low compared with other countries, which suggests there should be significant growth over the next few years. At the end of 2019, overseas investors held about 5.8% of A-share stocks and Hong Kong- and U.S.-listed Chinese stocks in terms of market capitalization, according to an April report (link in Chinese) from Tianfeng Securities Co. Ltd. That compares with 34.7% for South Korea, it said.
Regulators have resolved many of the concerns expressed by index providers such as MSCI and by financial institutions — including excessively long trading suspensions and controls on hedging. But there are still a plethora of obstacles including different rules for different investment programs, insufficient tools for risk management such as short selling, caps on foreign holdings in stocks, controls on moving capital out of the country, and compliance with regulations on issues such as data localization and cybersecurity.
In November, MSCI announced the completion of the final phase of its proposal to increase the weighting of A-shares in its indexes. But it also reiterated that no further inclusion of A-shares would take place until after a public consultation to review China’s progress in addressing the remaining market reforms investors are seeking to resolve concerns about issues including access to hedging and derivatives instruments, the short settlement cycle for A-shares, and different trading holidays between the stock connect programs linking Hong Kong and mainland markets.
In a letter to the European Commission in February, the Asia Securities Industry and Financial Markets Association (ASIFMA), a Hong Kong-based trade association of financial institutions, listed a string of recommendations to help foreign investors access and navigate mainland markets.
One of the top remaining complaints of foreign investors is continued insufficient access to hedging and derivatives instruments that would allow them to bet both ways on the direction of the market and manage their risks. Investors using the QFII and RQFII programs, for example, aren’t able to use some hedging instruments that investors using other channels are allowed to use. Bond investors in the programs want to be able to use additional hedging tools including onshore repurchase agreements, interest rate swaps and futures, according to ASIFMA, although the government has started to allow some of these. They also want clarity on whether they can use offshore products linked to the interbank bond market to hedge their onshore bond holdings.
“International institutional investors require liquid on and offshore index futures and options contracts in order to expand their allocation to China and manage their increased exposure,” MSCI said in November. “Index futures and options contracts are critical risk management tools for global investors, particularly for complex, deep and varied equity markets such as in China.”
Although there are onshore futures products for stocks, there’s a dearth of options for international investors to hedge their China risks outside of the mainland. Currently, the Singapore Stock Exchange is the only overseas platform where investors can trade Chinese A-share futures — through the SGX FTSE China A50 Index Futures which tracks 50 mainland-listed stocks. In March 2019, MSCI and the Hong Kong Exchanges and Clearing Ltd. signed an agreement to launch futures contracts on the MSCI China A Index, which will track the entire 421 large- and mid-cap A-shares included in the benchmark MSCI Emerging Markets Index.
However, no launch date has been announced and the China Securities Regulatory Commission (CSRC), China’s stocks watchdog, has yet to approve the use of the futures.
There are concerns that the movements of offshore hedging tools could affect onshore stock prices. A partner with a law firm engaged in cross-border business told Caixin that if regulators fail to properly regulate offshore listed financial instruments that are linked to the A-share market, and there is any market manipulation or volatility offshore, that would inevitably be transmitted to the A-share market.
However, a person familiar with trading at a foreign investment bank told Caixin that there’s little evidence to back up that proposition. “The more open the market is, the smaller the gap with overseas markets is, and the less room there is for arbitrage,” the source said, declining to be identified.
Another challenge for overseas investors centers around shareholding restrictions. Under current regulations, a single foreign investor cannot hold more than 10% of the total issued shares of a mainland-listed company, and the total holdings of foreign investors in its A-shares cannot exceed 30% of its total issued shares.
These limits are increasingly becoming an issue as foreign investment in domestic listed companies has surged with the opening up of the market. In May, overseas holdings in three Shenzhen-listed companies — appliance-maker Midea Group Co. Ltd., testing services provider Centre Testing International Group Co. Ltd. and furniture-maker Suofeiya Home Collection Co. Ltd. — all exceeded 26% of their total issued shares, triggering alerts as they approached the 30% limit.
Under the stock connect programs, purchases of A-shares in any mainland-listed company by overseas investors are suspended when foreign ownership exceeds 28% of the total, as stipulated by the Hong Kong Stock Exchange. However, overseas investors can still sell shares under such circumstances and buying can resume when foreign ownership falls to 26%.
In March 2019, MSCI said listed companies approaching the overseas ownership limit would have their A-shares removed from its China indexes or have their weighting cut, citing “investability” issues.
Although Fang Xinghai, a vice chairman of the CSRC, said that same month that there were no plans to relax the restrictions, in January this year he told Bloomberg News in an interview that the regulator was looking at the issue and that there was potential to lift the limit to “more than 30%” given that other countries in the region have higher caps.
The head of the securities department at a large foreign financial institution, who declined to be identified, told Caixin that this limit should be relaxed. Suspension of buying causes a lot of trouble for investors and increases operational and compliance costs, he said.
However, a senior manager at another foreign institution said that maintaining the limit would help broaden the number of domestic companies with overseas shareholders by forcing investors to look at more stocks rather than sticking to the same small number of popular shares. “It’s not always good to see overseas investment focus on just a few stocks,” the manager told Caixin. “This can be very risky because if there are any signs of trouble in their investment in a company, foreign shareholders might all rush to sell simultaneously which would crush that company’s share price.”
Compliance is another headache for foreign investors, not only in the area of financial regulation but also, more recently in requirements for data localization and other issues specified in China’s Cybersecurity Law, which was enacted in June 2017.
“The opening of China’s financial market continues to be promoted, and we can really see it happening, but when it comes to implementation, there are still many constraints,” a senior executive with a foreign brokerage who declined to be identified told Caixin. “There are areas where we have to try and reconcile specific issues, such as fulfilling the regulatory requirements for setting up a company or shareholdings while at the same time ensuring that there is global coordination within our company. It’s really not easy.”
For example, Chinese regulations stipulate that for domestic securities and futures trading, investment decisions must be made independently, and no trading orders can be issued through foreign institutions or overseas systems.
Foreign private fund firms not only have to consider compliance in China, but also need to ensure their Chinese operations follow the compliance and risk control requirements at the group level, on issues including know-your-client guidelines, anti-money laundering, investment transaction risk control, and disclosure of holdings, an executive at an overseas private fund firm said.
Some foreign managers complain that it’s been difficult to share information and resources with their overseas headquarters because of data localization rules that form part of the Cybersecurity Law. Article 37 of the law requires entities operating what’s known as critical information infrastructure to store on domestic servers all personal information and important data gathered or produced on the mainland.
A lawyer that provides cross-border services told Caixin that it’s not impossible for data to be stored on servers located overseas as long as proper relevant arrangements are in place. Risk control, for example, can be done abroad, but final investment decisions and the placing of buy and sell orders need to be made over domestic terminals.
To get around the problems and the lack of clarity about some aspects of the Cybersecurity Law, some major foreign-owned private fund managers have come to an informal arrangement with the CSRC and the Asset Management Association of China, an industry group, that allows them to store data on overseas servers on the condition that transaction data are backed up in real time on the mainland.
Given the size of China’s capital markets, the government’s commitment to continue opening the financial sector to foreign institutions and growing overseas enthusiasm for investing in the world’s second-biggest economy, solutions to these thorny issues will eventually be agreed, some say. But Chinese regulators are likely to proceed cautiously in order to minimize any potential volatility to domestic markets. “Over the years, everyone has been cautious about the entry of foreign money into China’s capital markets,” a source within China’s regulatory apparatus told Caixin. “China’s capital markets are relatively immature and dominated by retail investors, so (the pace of) opening up has to be controlled. If we act rashly to open up, it would be tantamount to letting foxes into the hen house.”
Contact reporter Timmy Shen (firstname.lastname@example.org) and editor Nerys Avery (email@example.com)
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