Written by Gary Thompson, Head of Trading
China continues to open its market to foreign investors. The recent inclusion of 236 large-cap China A-shares in the MSCI All Country World Indices and its constituent indices (including MSCI Emerging Markets) is expected to lead to a notable increase in the number of first-time foreign investors entering the A-share market. The inclusion will be made in two steps and will not represent the full weight of the market. But a potential full inclusion of China A-shares could raise China's weight within the Emerging Markets Index to above 40%. As a result, interest in investing in China’s A-share market has risen sharply.
However, as China is an economy with a closed capital account, buying and selling investments is not as straightforward as it is in most other large markets. Below, we list the primary methods overseas investors are able to use to get exposure to Chinese A-shares as well as Chinese Depositary Receipts (CDR) that the government is in the process of launching.
Shanghai and Shenzhen Stock Connects
The Shanghai and Shenzhen Stock Connect programs are two-way market access programs that provide trading and clearing links between the mainland China and Hong Kong markets. The Shanghai-Hong Kong Connect went live in November 2014 and currently gives foreign investors access to 576 of 1,217 Shanghai-listed securities. The Shenzhen-Hong Kong Connect followed in December 2016, providing foreign investors access to 904 of 1,903 Shenzhen-listed securities.
How to invest on the Connect pipe.
There are three main ways:
1. Through a Special Segregated Account (SPSA). This allows an investor to choose from a range of brokers to execute transactions on an account-by-account basis and provides real time delivery versus payment.
2. Through an integrated custody plus model, where broker and custodian are the same. Execution is done through an omnibus account. Multi-broker execution is not possible.
Both choices offer standard settlement (T+1 for buys; T+0 for sells), which has been a concern for foreign investors as settling on such a tight deadline across time zones leaves virtually no margin for error for settlement teams. To overcome this issue, the Stock Connect recently introduced single-sided settlement, in which the executing broker takes responsibility for delivering the stock or cash, as required by the trade. This reduces the risk of a snafu for overseas investors. Under this arrangement, the local custodian will settle a trade from the broker’s instructions. The foreign investor then reconciles their settlement based on the broker’s confirmation alongside a dedicated reconciliation file of (single-sided settlement) trades provided by the client’s local custodian.
3. Synthetic Access – e.g., promissory notes. Here a foreign investor is able to make use of a broker’s QFII/ RQFII quota. The broker would underwrite the U.S. dollar-denominated note that will perform in line with the underlying shares, although, as a P-note, this carries the counterparty credit risk of the issuing broker. With this arrangement, no offshore currency (CNH) funding is required by the investor. Settlement is on an easier, T+3, basis.
The Stock Connect arrangement runs with a limited volume basis. Although the aggregated quota was abolished back in August 2016, the pipes still operate on a daily quota basis for both Northbound and Southbound flow. Most recently however, with the MSCI inclusion as the catalyst, the original daily quota was expanded 4x on each of the trading links, and this revised Northbound and Southbound daily quota stands at RMB 52 billion (U.S. $8bn) and RMB 42 billion (U.S. $6.5bn) respectively, for each exchange, providing decent liquidity.
Qualified Foreign International Investor (QFII) and RMB Qualified Foreign International Investor (RQFII) accounts
Launched in 2002 and 2011 respectively, the QFII and RQFII programs allow investment into mainland China through a maximum investment quota for each investor. The advantage of the QFII and RQFII accounts is that they allow foreign investors to buy any RMB-denominated A-shares on the Shanghai and Shenzhen Stock Exchanges – so they offer a broader choice than what's available through the Connect. They also allow investors access to IPOs that currently are not available through Connect. The quotas allocating RMB have expanded steadily, and today there are currently 283 QFII issued licenses with US$93bn of quota. A further 184 licensed RQFII investors have a US$86bn of quota. The current utilization rate of these quotas stands at around 30% to 40%, compared with 70% to 80% before the Stock Connect became available. A recent rule change in June 2018 removed a restrictive rule governing an investor’s ability to repatriate funds from QFII and RQFII accounts. This limit had been a significant drawback of the QFII and RQFII program, and the removal will likely lead to renewed interest in and use of these avenues.
China Depositary Receipts (CDRs)
This is a new program that Chinese authorities are trying to launch. The idea is to offer mainland Chinese investors access to investments in Chinese companies that have listed offshore only (such as Tencent or Alibaba). Earlier this year, China’s State Council announced a pilot program that would allow overseas-listed Chinese companies to list domestically through depositary receipts on the Shanghai (and possibly the Shenzhen) stock exchange. Qualifying companies gain from being able to tap fresh equity in their home market as well as having an alternative to listing in Hong Kong. It remains unclear whether such CDRs would be fungible between markets (Shanghai and Hong Kong). That seems unlikely to us, given the closed capital account. If these CDRs are not fungible, it seems likely that valuation differences will emerge between the offshore and CDR prices.
As the U.S.’s protectionist stance on technology escalates, the development of the CDR will be an interesting read of China’s view. Most recently, China’s smartphone company Xiaomi became one of the first companies to apply for the CDR program. However, at the time of writing it is not clear if this listing will take place, given the volatile markets. We anticipate that once the Chinese manage to launch their CDR program, there will be a fair amount of pressure on managements of other leading Chinese technology companies to follow suit – to help keep the dramatic earnings growth from some of these companies to benefit Chinese savers, while reducing the dependence on overseas markets to host the listings of some of China’s leading enterprises.
In summary, with the increased opening of the Chinese equity markets to foreign investors, we expect a considerable increase in the number of foreign investors investing into Chinese A-shares.
Disclosures and Disclaimers
Past performance is not indicative of future results. Any companies described in this commentary may or may not currently represent a position in our client portfolios. Also, any sector and industry weights described in the commentary may or may not have changed since the writing of this commentary. The information and methodology described in this commentary should not be construed as a recommendation to purchase or sell securities.
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