Understanding RQFII The Great Door Opener for China Access

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1 Markets and Securities Services Investor Services Understanding RQFII The Great Door Opener for China Access By: Stewart Aldcroft, Citi Investor Services Since China first started opening up its capital markets to the rest of the world in 1991, it has also greatly added to the lexicon of acronyms in the financial services business. Whether it be in respect of the simple initials of Regulators, such as CSRC (China Securities Regulatory Commission), SAFE (State Administration of Foreign Exchange) or PBoC (People s Bank of China), or the initials of the products and/ or services they allow, including: QDII (Qualified Domestic Institutional Investor), QFII (Qualified Foreign Institutional Investor) or the latest, RQFII (Renminbi-Qualified Foreign Institutional Investor), it is clear that those in the asset management business need to keep up to date and informed. This is especially true of the developments concerning gaining access to the China A Share markets, which can be somewhat like the Holy Grail for fund managers, if got right. At present, the regulators in China have been reluctant to open up their markets widely to all-comers, and have adopted a policy of slowly letting investment professionals in the door. In part, this is to provide some protection to the existing fund management regime in China, it also reflects the national policy of slowly allowing the Chinese currency, the Renminbi (RMB) to become traded across the globe, increasing convertibility of it, with an ultimate aim that in time the Yuan (as it is known locally) could become a reserve currency, somewhat like the US dollar or the Euro. How Far has RQFII Come? Since May 2003, when the first QFII quotas were granted by SAFE, this has been the most widely used route by global fund managers to gain direct access to the Mainland securities markets, to buy China A Shares and Chinese Bonds and Fixed Income securities. In the 11 years since this started there have been over 250 allocations exceeding US$49bn. Globally, almost all major fund managers, leading pension funds and some substantial insurance companies have availed themselves of the facility. By proportion, the numbers of US-based institutional investors and fund managers that have taken a QFII License far exceed that of most other parts of the world. But QFII has limitations. It is somewhat inflexible, as it doesn t allow for daily inflow/outflow of monies, as occurs with open-ended mutual funds. Initially it prescribed the proportions managers were allowed to invest into equities and fixed income. But as experience developed, for both China and the global managers, some of the inflexibilities were lessened. Nevertheless, there are a number of additional requirements imposed upon the managers to ensure that when they receive and use QFII it is for longterm investing, thus, for example, hedge funds are generally excluded from the scheme. On the other hand, getting a QFII License does not depend on location or licensing, thus managers and funds from the US, Canada, Europe, Asia, Japan and Australia have all succeeded in receiving quotas.

2 Markets and Securities Services Investor Services RQFII is designed as a refinement on the QFII product, and is more targeted to locations where there is substantial trading in RMB. Thus, initially Hong Kong was granted a quota of RMB270bn, and subsequently in July 2013 London (RMB80bn) and Singapore (RMB50bn) were added to the list. In late-march 2014 France (Paris) also received a quota (RMB80bn). A notable improvement on the earlier scheme has been that the RQFII quota, if used for open-ended funds, may be allocated among a number of them (within the same fund house), which makes use of it infinitely more flexible than before. This allows, for example, a fund manager offering multiple funds with a range of geographic and/or sector biases, to split the quota among as many of these as may be desired, and increase or decrease proportions in accordance with investment considerations, rather than be required to hold stocks indefinitely regardless of underlying market conditions. Another valuable consideration for RQFII is that the minimum size of quota can be as low as RMB300m (US$48m), depending on the type of vehicle for which it is being applied. QFII & RQFII Market Developments China has been opening up its capital market through aggressively buoying both QFII and RQFII schemes in Apr 2012 QFII & RQFII quota ceiling increased QFII: from $30 to $80 RQFII: from RMB 20 to RMB 70 ; RQFII ETF issuance allowed Aug 2012 PBOC revises rules for RMB settlement account of QFIIs Nov 2012 RQFII quota ceiling increased from RMB 70 to RMB 270 Jan First batch of QFIIs approved for index futures trading Mar PBOC releases new regulations enabling QFIIs to invest in China s interbank bond market May QFII/RQFII online application platform released by CSRC July RQFII granted to non- Chinese financial institutions in HK Oct 2013 RQFII quota of RMB 80 and 50 granted to London and Singapore respectively Jan CSRC confirms license application and investment operations of London and Singapore RQFIIs will follow the HK scheme Jun 2012 CSRC publishes revised QFII rules to public which lowers entry requirements and simplifies QFII applications Sep 2012 QFII Global Roadshow conducted by CSRC, SAFE and stock exchanges Dec 2012 Rules for QFIIs revised by SAFE. Adjustments mainly in account administration, single quota ceiling, QFII injection and repatriation rules Feb QFIIs allowed to appoint multiple brokers at each stock exchange Mar CSRC lowers RQFII entry requirements, simplifies approval process and expands scope of RQFII investment Mar SAFE revises RQFII rules mainly on quota management July QFII ceiling increased to USD150 ; RQFII pilot program expanded to Taiwan, Singapore and London Aug QFII quota in excess of one granted to single license holder Nov The requirement of 70% of fund asset to be invested into China onshore securities market for QFII China open-end fund removed by SAFE. 2

3 Why Should Global Fund Managers Consider Becoming an RQFII Manager? China s stock markets in Shanghai and Shenzhen, if based on the major indices by which they are measured, i.e. the FTSE A50 or the CSI 300, have been very disappointing. Over the last 5 or 6 years they have either flat-lined or gone down, thus unattractive to stock market investors. On the other hand, the Chinese fixed income market (bonds) has proven to be very attractive, due to the winning combination of high yields and falling interest rates, and a currency that has steadily increased in value against the US dollar, the Euro and most other major currencies. There are a number of questions many in the fund management business now ask: Whether (and/or when) will the equity markets in China become attractive again from an investment perspective? This however fails to note that many sectors and sub-sectors of the Chinese stock markets having been doing extremely well over the last 5 years. With more than 2,500 stocks now listed, a market capitalization of more than US$3.8 trillion, covering a broad range of sectors, by industry or geographic classification, with both large, medium and smaller capitalized stocks all being actively traded, there is plenty of choice for the discerning investor. Indeed, for those that closely follow stock market indices, they would have observed that many medium, smaller cap, sector and regional indices have performed exceptionally well over the last 1, 3 and 5 years, some up by more than 150%. When will China be included in the major global, regional and emerging markets stock indices? Despite their obvious size, in the major indices such as MSCI World or Emerging Markets or FTSE Emerging Markets, Asia ex- Japan, etc., China represents a very small proportion, for example in the World Index it is less than 0.2%, whereas if based on market cap weightings, it might be nearer 8%. The major index providers have been discussing for some time when and how they will increase the weighting of China in their benchmarks. This will be dependent on the continued opening up of both the market and the currency, to become more freely traded. Many are forecasting this to occur by 2017, thus much preparation is needed before then. In market cap terms, China is the fifth largest stock market globally. In index-weighting terms China doesn t even make the top twenty! Why is this important? Because many fund managers and especially their pension fund and institutional investor clients aim to benchmark their portfolios against major indices. Thus, in the event of China taking a significantly larger proportion of an index, it can be expected there will be a large flow of money into the market to avoid lack of market exposure thus underperformance against the index. Any large inflow is likely to trigger a far more positive stock market performance as well. Who will be the managers that get this money? It will probably be those managers who have been able to demonstrate experience in managing Chinese equities, especially over an extended period of time. To do this, it is valuable to build experience now, rather than wait until the demand is high. While fund managers within China have, for obvious reasons, had far more experience and local expertise, this does not preclude global or even some regional fund managers also offering their own unique skills to manage Chinese equities, when the opportunity arises. RQFII and QFII What are the differences? As the table below shows, the rules for RQFII are more flexible and aim to favour use by active fund management companies offering their products to end investors. Initially offered in December 2011 to Hong Kong, in late the scheme was also extended to asset management businesses located and licensed in London and Singapore and in late-march 2014, France (Paris) was added. It is also expected to be offered to Taiwan during 2014, subject to the Taiwanese Government implementing a Trade Agreement with China. The key feature, especially of the London and Singapore variants of the RQFII scheme, is the openness of the type of product to which the scheme can be applied. Thus, in both locations, open-ended investment funds (mutual funds or unit trusts) can be the vehicle using the scheme. In addition, there are no restrictions on the types of assets listed on the Chinese stock exchanges that can be used. Whilst in the past, many users of the first round of QFII and RQFII may have stuck to stocks included in the main indices, the largest (by market cap) companies, or other familiar names, under the latest RQFII Guidelines it is possible to invest into medium and smaller cap stocks, IPOs or just about anything, provided it is listed on one of the two exchanges. This gives significantly more flexibility to achieve better returns, and will enable those fund managers with specialist investment styles to employ their style to Chinese stocks, without limitation. Another key difference when compared to the earlier QFII scheme, is the recognition that open-ended funds see money flows in and out daily, thus for the RQFII scheme, fund managers can similarly conduct their inflow/outflow of Chinese stocks daily, if needed, to match the movement of money of their clients. 3

4 Markets and Securities Services Investor Services Comparative Analysis of Capital Market Access QFII RQFII Interbank Bond Market Regulator CSRC, SAFE CSRC, SAFE PBOC Criteria of Applicants Commercial Banks In operation for more than 10 years Securities AUM no less than USD 5 Tier 1 Capital no less than USD 300 million Securities Companies In operation for more than 5 years Securities AUM no less than USD 5 Capital no less than USD 500 million AMC, insurance companies and other institutions Business experience of more than 2 years Affiliates of qualified China mainland fund management companies, securities companies, commercial banks or insurance companies in Hong Kong/London/ Singapore, or financial institutions registered and mainly operated in Hong Kong/London/ Singapore respectively. Has obtained asset management license from Hong Kong/London/ Singapore regulators and already conducted asset management business. RMB clearing banks in Hong Kong and Macau Off-shore RMB clearing participating banks for cross-border trades Offshore central banks and monetary authorities Other Off-shore RMB clearing financial institutions for crossborder service and trade pilots Securities AUM no less than USD 500 million Investment Scope Stocks, bonds, funds, warrants, IPOs, bond issuance, government bond preissuance trading and index futures Stocks, bonds, funds, warrants, IPOs, bond issuance, government bond preissuance trading and index futures Limited to bond issued/ traded in interbank market FX Required Not required Not required Markets Accessible Stock Exchange Interbank Bond Market Stock Exchange Interbank Bond Market Interbank Bond Market CFFEx CFFEx Getting an RQFII License To enable the scheme to be more successful, the CSRC, which administers the issue of RQFII Licenses, has greatly speeded up the processing of Applications. In general, it expects an Application to be made on behalf of the fund manager by a designated custodian of the assets such as Citibank. As the role of the custodian is to act on an investor s behalf in China, it will also take responsibility for opening appropriate accounts with banks and securities companies to enable trading to occur and monies to be held. The speed with which a License can be given will often be determined by how complete the Application is in the first instance. It has been known for this process to take 2-6 months, depending on the jurisdiction in which the application is made. Once granted a License, the second part of the process is to get a quota from SAFE. The size of the quota can vary in accordance with the needs of the fund manager, to the extent the product is an open-ended fund, the additional feature of daily liquidity, no lock-up or book build deadline will be available, making the product more in line with global funds and fund practices. 4

5 But we re not located in an RQFII allocation centre. What can we do? As currently only managers and investors established and Licensed in the four locations, Hong Kong, London, Singapore and Paris, can apply for RQFII, many managers in the rest of the world are asking whether it is possible for them to do something. France (Paris) was added to the list in late-march 2014 so will possibly be an alternative to London for French managers when more details are announced. This can be answered in two ways. First, many global managers have multiple offices around the world. Typically, many have set up a European base in London, as that has often been regarded as the most international of locations providing all the services and counter-parties required. But if you want to be in Asia, then opening an office in either Hong Kong or Singapore is highly recommended. Again, both locations offer a full range of service providers, including investment banks, securities brokers, experienced analysts, etc. So, now you are all set up, what next? Managing the assets of a China Fund takes time and some significant level of research. Many fund managers may well have the resources to do this themselves. Others might want to work with managers in China or Hong Kong that have some previous experience. This is something Citi is very familiar with, as it sees both sides of the issue. Chinese owned or based fund managers may well be successful within China, but once they move overseas they no longer have any branding with which to capture success. But similarly, global fund managers have no brand in China either, thus it would benefit them to be willing to form cooperation agreements with which to work more closely with Mainland-based firms. Stewart Aldcroft Senior Advisor, Asia Pacific Investor Services, Citi Given the size of the Asian markets, the growth of wealth in the region and especially the volume of assets being managed out of the region, seeking an RQFII License might just prove to be the right excuse with which to make the move East. Another alternative might be to seek to work with partners that might already have an RQFII License, or are seeking one, to borrow or rent part (or all) of the quota. The partner may well also be able to provide asset management skills, intimate knowledge of the Chinese equities market, and thus guide those less familiar with these markets, on building up that knowledge. 5

6 Notes

7 Notes

8 2014 Citibank, N.A. All rights reserved. Citi and Arc Design is a registered service mark of Citigroup Inc /14

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