As part of its goal to open its capital account, China has said that that it will continue to open up its capital markets to foreigners and to let Chinese households invest more abroad. This post looks at the different methods for accomplishing these goals and analyzes the evolving role that China’s equity markets play in cross-border capital flows. Currently foreign investors can purchase Chinese equities through the Qualified Foreign Institutional Investor (QFII) program, the Renminbi QFII program (RQFII), and the much newer program, the Hong Kong-Shanghai Stock Connect.
Qualified Foreign Institutional Investor (QFII)
Launched in 2002, QFII allows foreigners to invest in A-shares in Shenzhen and Shanghai. In the first five years, Chinese regulators granted only around 50 institutional investors access to the program. They also set a limit to how much they were able to invest; this quota was under $10 billion until 2007. Now there are more than 250 approved institutional investors. QFII offers a range of investment options, including equities, bonds, exchange-traded funds, warrants, and futures (only renminbi denominated products are available). Note that foreign investors currently hold only 2 percent of the onshore bond market and just 3 percent of the market capitalization of the equity shares. There are some restrictions on shareholding: A single QFII investor can only hold up to 10 percent of one company, and all QFII investors together can only hold up to 30 percent of a single company.
Uncertainty around some regulations still deters the program. For example, in the QFII program foreign investors can only take out capital on a weekly basis (although this could soon change), and until February of this year, investors did not know if they would have to pay capital gains taxes (China now says it will collect 10 percent on profits claimed for the five years up through November 2014; there is currently a temporary tax reprieve). Although the quota has continually increased, the actual investment has increased only marginally up to 2013 (the latest available data), meaning account holders are not taking advantage of their quota increases and purchasing Chinese assets (figure 1).
Figure 1 Quotas for the QFII, RQFII, and QDII programs, and total assets of QFII
Renminbi Qualified Foreign Institutional Investor (RQFII)
RQFII was started in 2011 and is similar to QFII, except that at its inception, the program allowed renminbi-denominated funds located in Hong Kong to purchase assets in mainland China. The program has been broadened to allow offshore renminbi raised from international banks and asset managers that have a presence in Hong Kong to participate. Chinese regulators have specified that 80 percent of the quota (currently almost RMB 400 billion) must be in fixed assets, such as the interbank bond market, and the rest can be used to purchase A-shares. RQFII recently expanded to South America through a RMB 50 billion quota set up with the China Construction Bank in Chile as part of China’s plans to further internationalize the renminbi.
Qualified Domestic Institutional Investor (QDII)
Certain Chinese investors have been able to purchase Hong Kong stocks through the Qualified Domestic Institutional Investor (QDII) program since 2007. Here, investors can only purchase foreign equities through funds and other groups, they cannot purchase stocks directly. This program endured a slow start, with the total value of QDII funds falling from RMB 64 billion at the end of 2012 to RMB 49 billion near the end of 2014. However, the value shot up along with the stock market rise to over RMB 100 billion in June (see figure 2). This slow start could have occurred because China had previously been too cautious in allowing capital to move out of the country. Investment options are also limited to just 97 publically offered QDII funds, which have grown by only 30 since 2012. Another reason may be that wealthy Chinese have other ways of getting capital out of the country and therefore prefer underground channels that will be harder to shut down in times of a crisis. China is looking to revamp the program, a possible QDII2, which is in line with their strategy for renminbi internationalization. This program will be piloted in six cities and will allow individuals to invest directly (rather than through funds) in global markets besides Hong Kong.
Figure 2 Value of QDII funds
Shanghai–Hong Kong Stock Connect
China’s lastest attempt to open up the equity markets is the Shanghai–Hong Kong Stock Connect program, launched in November 2014. This program represents significant progress in cross-border equity exchanges, as anyone with a broker account in Hong Kong or Shanghai can purchase equities in the others’ exchanges.
There are requirements on who can participate. All Hong Kong and overseas investors (with broker accounts in Hong Kong) are able to buy stocks through the stock connect. But in mainland China, only institutional investors and individuals with more than RMB 500,000 assets in their accounts can participate. For the northbound (Hong Kong to Shanghai) investors, they can only invest in large cap equities on the SSE 180 index and the SSE 380 index, plus any firms that are listed on both the Shanghai and Hong Kong exchanges. For southbound investors, all equities listed in the Main Board of the Hong Kong exchange are included. Chinese regulators impose quotas, not on the amount an individual investor can invest across the border but on the net cumulative total investments of all one-way investments. China allows slightly more daily northbound (from Hong Kong to Shanghai) trading volume than southbound (RMB 13 billion for Shanghai versus RMB 10.5 billion for Hong Kong). Another measure to control the capital flow is the aggregate total, meaning the total amount purchased by all investors. When that total is reached, China must decide how much to raise it. As of July 20, neither Hong Kong nor Shanghai had used more than half of their aggregate totals (the northbound had used RMB 126 billion of its RMB 300 billion, and the southbound had used RMB 91 billion of its RMB 250 billion quota).
The stock connect has been a mild success since it began operations, especially in transferring capital from Hong Kong to China. Honk Kong trading of A-shares averaged a daily turnover of RMB 5.4 billion before April 1, and RMB 9 billion since then, though the most recent figures have come down closer to the pre-April 1 figure (see figure 3). As for Chinese nationals investing in Hong Kong, the data isn’t as optimistic: Daily volumes went from RMB 1 billion before April 1 to around RMB 5.6 billion since then, although recent volumes have fallen back to the RMB 2 billion to RMB 3 billion level (see figure 3-a). One reason for the dramatic increase in Chinese nationals investing in Hong Kong after April 1 was that around that time Chinese regulators allowed mutual funds to buy Hong Kong shares using the stock connect, and retail investors were allowed to open multiple brokerage accounts.
Figure 3 Stock connect northbound: Buy, sell, and turnover
Figure 3-a Stock connect Southbound: Buy, sell, and turnover
China’s various programs to allow investors cross-border access to equities have seen mixed success. One of the key points here is that very little capital is flowing in either direction through these programs. How much would this change if more restrictions were lifted? After the recent turmoil in the Chinese stock market, it is likely that many mainland investors are looking abroad as a relatively safe place to invest, but with such a high entry limit for individuals to participate in the stock connect, flows remain restricted. China should begin to gradually lower the half million renminbi requirement for individuals, to give more of its citizens a chance to increase diversity in their assets.
The authorities are looking to revamp (QDII2) or expand existing efforts (a Hong Kong–Shenzhen Stock Connect is planned for later this year). The amount of money these programs move across China’s borders will likely increase dramatically in the next couple of years, even in the face of the recent stock market correction. The success of these programs will help/encourage China to further liberalize its capital account and have greater control over capital flows. Having effective and official methods of bringing capital in and out of the country is better than underground alternatives, which could cause serious problems should China experience a crisis in capital outflows.