China’s decision to allow foreign investors to trade its newly-launched stock index futures is widely viewed as an essential move to open the country’s long-isolated capital market further to the outside world. However, questions remain on how fast and thorough the deregulation will be.
The agreement on foreign participation was sealed at last week’s meeting of the US-China Strategic & Economic Dialogue in Beijing. Both foreign joint ventures with access to the equities market and overseas institutions licensed under the Qualified Foreign Institutional Investor (QFII) program are expected to trade the derivative. No timetable was unveiled.
The China Financial Futures Exchange launched on April 16 to trade four contracts based on the benchmark CSI 300 Index, which tracks the biggest 300 companies listed in Shanghai and Shenzhen by market value.
Regulators set high thresholds for the new market in order to curb risk: Participants will have to put down at least RMB500,000 (US$73,100) to open an account. The contract values are points of the CSI 300 multiplied by RMB300, meaning each contract could easily exceed RMB1 million. Investors must pay cash deposits equivalent to up to 18% of the contract value to start trading.
Permitting foreign involvement offers the immediate benefit of adding experienced institutional investors to the market, which should help minimize volatility. It also gives foreign investors an opportunity to hedge against risk.
At present, overseas investors are restricted to increasingly moribund B-shares, which are traded in US dollars and Hong Kong dollars in Shanghai and Shenzhen respectively. Only the 88 QFIIs can buy renminbi-denominated A-shares, and their collective pot stands at US$30 billion, of which US$17 billion has actually been allocated. By comparison, the mainland stock market has a total market capitalization of US$2.7 trillion.
It may take two to three years for foreign investors to build up the enthusiasm and knowledge to play a real role in the mainland securities futures market.
First, Chinese authorities will certainly tread very carefully in approving QFIIs and other foreign firms for futures trading. Final rules of participation probably won’t emerge for several months and it will take even longer to make the mechanism really work. Second, China is highly unlikely to make the renminbi fully convertible in the near term and this is natural barrier to greater foreign investment in the country’s capital market.
Those Chinese observers who fret that foreign investment banks will abuse the derivatives system in the same way that brought about the Western financial crisis can rest easy: Beijing will not allow free rein.
One big uncertainty is whether regulators will grant QFIIs new investment quotas or require them to use their existing quotas to trade index futures. It is also unclear how other Sino-foreign joint ventures could join in the program.
Participation in the futures market has so far been restricted to retail investors and domestic institutions such as brokers and mutual funds, although institutions are only allowed to sink 20% of their funds into the new products.
If China doesn’t issue new quotas to QFIIs while place similar restrictions on the hedging activities, their influence on the index futures market will therefore be minimal compared with Chinese counterparts. The likes of Martin Currie and AMP Capital have said that index futures could help them better manage their mainland exposure, but this is doubtful.
The market will likely remain dominated by retail investors, and this isn’t good for index futures or equities.
The rationale behind launching index futures was that it would reduce fluctuations in a stock market that has become Asia’s worst performer this year following an 80% rally in 2009. However, the CSI 300 index has fallen about 20% since index futures came in, and in the fluctuations seen in intraday trading are still wide.
According to exchange data, each account traded more than six times per day during the first two weeks of the futures trading. This seems to suggest that some investors are using index futures as an alternative investment rather than a hedging tool.
Watching events unfold in this manner, the QFIIs may be inclined to sit on the sidelines and learn how to play a familiar game in an unfamiliar market. They are unlikely to want to engage in hedging activities while the bulk of their domestic counterparts are making speculative and unpredictable bets.
In this respect, the announcement at the Sino-US dialogue could be seen as nothing more than a goodwill gesture. It doesn’t herald any fundamental change to foreign participation in China’s fledging capital market – because neither the Chinese authorities nor the foreign participants themselves are ready for it.