China has taken a significant step towards opening its securities market to foreign capital. However, overseas investors are unlikely to rush into the market, according to Yue Tang of Jun He law firm in Beijing.
Last November, the Chinese Securities Regulation Committee (CSRC) and the People's Bank of China jointly enacted the Administrative Measures on Investing in the Securities by Qualified Foreign Institutional Investors (QFII). The introduction of the QFII rule shows that China has taken a significant step towards opening its securities market to foreign capital. It is expected to serve two functions: to improve the quality of the domestic securities market and public companies in particular; and to attract more foreign capital into the securities market.
QFII refers to the overseas fund management companies, insurance companies, investment banks and other capital management firms which, upon the approval of the CSRC, can invest in China's securities market by using an investment quota approved by the State Administration of Foreign Exchange (SAFE).
Foreign company requirements
These foreign companies must satisfy specific requirements set out in the QFII rule. Fund management companies must have existed for at least five years and the value of total assets under their management must exceed US$10bn in the most recent year. Insurance companies must have existed for over 30 years, with net capital exceeding US$1bn and more than US$10bn of total assets under management. Investment banks also must have existed for over 30 years and have total assets under management of more than US$10bn. Commercial banks must feature among the world's top 100 in terms of total asset value, and the value of securities under management exceed US$10bn.
A QFII may, within the approved investment quota and upon approval by the CSRC, invest in A shares, government bonds, convertible and non-convertible company bonds, and other financial instruments that are listed and traded on the stock exchanges. It is not allowed to invest in mutual funds.
QFIIs must comply with the provisions of the Foreign Investment Industrial Guidance Catalogue, which lists industries in which foreign capital is permitted, encouraged, restricted or prohibited.
A single QFII is not allowed to hold more than 10 per cent of the total number of stocks of a particular public company. In addition, the combined stocks held by all QFIIs may not exceed 20 per cent of the total number of the stocks of an individual public company.
The QFII must entrust a qualified Chinese commercial bank as a trustee to manage its assets. A foreign-invested bank, after operating three consecutive years in China, may also apply to qualify as a trustee. The trustee shall open a separate account for the QFII; each QFII may only entrust one trustee. The trustee is mainly responsible for keeping the assets of the QFII, handling foreign exchange transactions and settling the investment fund. The QFII must also entrust a Chinese investment bank, rather than a foreign investment bank, to handle the purchase and sale of the securities.
To attract long-term capital investment, preference would be given to close-end Chinese funds and other pension funds, insur- ance funds and mutual funds that comply with the rules of the capital markets and have not been punished by the capital market for breaking the rules in other capital markets.
The QFII may, with the approval of the CSRC and SAFE, transfer its investment quota to other QFIIs if the principal has been remitted into mainland China for between three months and one year.
Before the QFII Rule was enacted, most foreign capital channelled into China came in the form of direct foreign investment. This is an important reason why the authorities have now turned to the QFII.
Indirect foreign investment started with B share companies. However, there are only a limited number of such companies and their market value is much lower than their A share counterparts. The A share market is the main vehicle for domestic companies to raise capital and is widely regarded as an emerging market with significant growth potential. The total capitalisation of the A share market is about US$500bn, putting it second only to Japan in Asia. By 2010, its total market value is expected to increase to US$2,000bn to US$3,000bn. With QFII, foreign capital is allowed access to A share companies for the first time.
There are more than 1,100 public companies listed and traded on the Shenzhen and Shanghai stock exchanges. Among them, according to an analyst from global investment bank UBS Warburg, there are 80-90 that might be attractive to foreign investors. They fall into four types of industries:
state-monopolised industries, including airports, ports, highways and telecoms;
industries with local characteristics, including liquor producers and textile manufacturers;
industries with well-known brands, including domestic electronics producers;
and natural resources industries, including mineral resources and tourist industries.
Problems with the rule
It remains unclear whether or not the QFII rule will succeed in attracting foreign capital into the securities market. Capital infusion is a complicated process that involves a range of factors. There are three major problems:
The assets threshold is too high, keeping out some prospective investors. For example, to qualify as a QFII, a commercial bank needs to be among the world's top 100 in terms of total assets. The QFII rule does little to help Hong Kong banks that are interested in the mainland securities market.
There are fundamental problems with the share structure of most public companies. Many evolved from state-owned enterprises where the government was the sole shareholder. Such enterprises were transformed into public companies by issuing stocks to the investing public, but the majority of stocks are still held by the government. A public company's stock consists of two types: stocks held by the government or state-owned companies; and stocks held by the investing public, known as trading stocks. Of the two, only trading stocks can be traded on the stock exchanges. According to an article in China Securities Daily last November, the average ratio of stocks of public companies held by the government or state-owned enterprises was 44.68 per cent. For the QFII, it may only buy and sell the trading stocks listed on the stock exchanges, which on average only constitute 55.32 per cent of the entire stocks of public companies.
There are also apparent problems with the corporate governance of public companies, which are partly a consequence of this high stock ratio. For instance, majority shareholders control the shareholder meeting and the board of the directors. They also tend to usurp capital from the public companies and manipulate their financial statements by causing the public company to execute transactions with its affiliated companies. The profits of some public companies are largely the result of unfair transactions with their affiliated companies, rather than transactions with unrelated third parties, which are conducted under a fair price. To make the financial statement look attractive, one of the common practices for the majority shareholder is to arrange a transaction between the public company and its affiliate company. Under such a transaction, the public company will sell certain assets to its affiliated company in exchange for some assets from the latter. It looks like a normal asset exchange deal. However, although the actual value of both exchanged assets are similar, the assets from the affiliated company are valued at a price much higher than its actual value, and therefore the public company makes a profit from the transaction.
According to authoritative sources from the CSRC, more than 30 foreign financial institutions have so far expressed interest in becoming QFIIs. However, considering the problems highlighted above, it is unrealistic to anticipate that they will become an attractive proposition in the short-term. During the first couple of years after enactment of the QFII rule, foreign institutional investors are likely to be quite cautious. According to an analyst from Deutsche Bank, they are unlikely to rush into the A share market; instead, they would start by investing in the
less risky bonds markets. During this transition period, they would undertake research in the A share market, and invest only when they believe it is the right time.
This article was written by Yue Tang of the Jun He law firm in Beijing. Established in 1989, Jun He is one of the most prestigious China-based law firms, with over 130 attorneys in six cities: Beijing, Shanghai, Haikou, Dalian and New York.