China's QDII: Banks get the green light

Implications: China's qualfied domestic institutional investor (QDII) initiative has now been expanded to allow Chinese banks to invest their QDII quota in foreign equities. The impact of this development is, however, likely to be muted as investors continue to both pour money into Chinese domestic equity markets and foresee an appreciation of the yuan. For foreign financial institutions, expansion of the QDII may lead to opporutunities to promote their equity-linked products in China.

Analysis:

On May 11, the China Banking Regulatory Commission (CBRC) gave Chinese banks the go ahead to invest some of their holdings in foreign equities. This is the first time that Chinese banks have been allowed to do so.

The news pushed up the Hang Seng index in Hong Kong to a record high. Hong Kong is the jurisdiction expected to benefit most from this news. But what are the real implications of this decision, and how will they play out over the longer term?

Background

In April 2006, the CBRC in conjunction with the People’s Bank of China and the State Administration for Foreign Exchange (SAFE), issued long-awaited guidelines on China’s qualified domestic institutional investor (QDII) program. Under this program, certain banks, insurance companies, and asset managers can apply to SAFE for foreign exchange quotas to be used to invest in overseas financial instruments.

At the outset, banks could invest in fixed income and money market products is permissible. (By contrast, insurance firms and asset managers could always invest in foreign equities, though both types of institutions preferred the safety of fixed income and money market instruments.)

Over the past year, dozens of Chinese financial institutions have applied for, and received, QDII quota from SAFE. Over US$ 13 bn of quota has been granted, but less than 10% of that has been put to use investing abroad. Most of that has been invested in fixed income and money market instruments.

A-Share Euphoria and Yuan Fears

The reasons for the relatively paltry level of QDII in use are twofold. First, China's domestic equity market returned some 130% in 2006, and is up over 40% in 2007. Shanghai's A-share market has been the main draw from investors, but even the small cap Shenzhen market has performed well and attracted punters from across China. Second, since its first revaluation in July 2005, the RMB has continued to appreciate. Now at around 7.68 to the US dollar, most analysts (and investors) expect it to continue to rise for the foreseeable future. As a result, the vast majority of QDII-related funds designed to invest in overseas markets have gone un- or under-subscribed.

Adding to the woes of QDII quota holders is the fact that China's securities regulator has begun to impose a requirement that large companies seeking to list overseas also list in Shanghai. As these policies begin to take effect, there will be reduced need for investors to seek overseas assets.

Here Come the Banks

Given the predilections of Chinese investors and regulators to favor China's domestic markets, what will be the effect of the new policy of allowing banks to buy foreign equities?

In the short term, probably not much.

Chinese banks will begin to develop equity-based product offerings to take advantage of this new ruling, but are unlikely to get any more subscription than their asset-management counterparts. Diversification motives from the banks themselves will certainly spur some buying in the overseas markets, but in the near term, this is likely to be limited. Indeed, the sharp rise in the Hong Kong market after the CBRC's announcement seems overly optimistic.

Looking longer down the path, there will be some impact of banks participating in the purchase of foreign equities. We can expect some capital outflow from China if the authorities allow the yuan to appreciate to what the international community (read: US) deems an appropriate level. Thereafter, foreign assets may begin to look more attractive. Moreover, if China's financial regulators begin to do more than simply "regulate by pronouncement" (i.e., calling the market overheated rather than actually taking policy steps), there may be some inclination on the part of investors to look further afield.