QFII rules open Chinese markets to institutional investors

New regulations coming into effect this month mark a significant development of the securities market in China.

Qualifying Foreign Institutional Investors Investing in Domestic Securities Markets Tentative Procedures (the "QFII Tentative Procedures") were promulgated by the China Securities Regulatory Commission and the People's Bank of China on 5 November.

Key features of interest include:

Opening the "A" share and domestic bond markets to foreign investment for the first time;

Access to the "A" share (RMB denominated shares issued by PRC companies listed on one of the two domestic Stock Exchanges in Shanghai and Shenzhen) market was previously reserved only for domestic PRC individuals and institutions and consequently off-limits to offshore foreign investors.

The QFII Tentative Procedures mean that certain types of institutional investors outside the PRC which meet the relevant criteria can apply for approval to invest as Qualifying Foreign Institutional Investors ("QFIIs") in "A" share issuing companies, as well as in PRC government bonds, listed convertible bonds, enterprise bonds and other financial instruments approved by CSRC, albeit within the constraints of the framework set down in the QFII Tentative Procedures.

A vital building block towards improved corporate governance and compliance in domestically listed companies.

One of the reasons for the weakness in the compliance and corporate governance systems and records of many domestically listed PRC companies has been the historical predominance of the state as the majority shareholder, coupled with the lack of a counterweight in the form of a strong institutional shareholder culture: this meant that the state was, in its dual roles as investor and regulator, effectively acting as both player and referee.

Whilst the QFII scheme is not going to resolve the structural issues overnight, nor is it going to suddenly improve the compliance and corporate governance standards of "A" share companies, it should exert a positive influence over time. The presence of international institutions with their investment culture and values should support the development of an institutional investment culture in China and their longer-term investment horizons (as compared to the typical local individual investor) should also help to reduce volatility in the PRC market.

Entrenching international best practice

Many commentators have remarked that given the very high P/E ratios on which most "A" shares trade, QFIIs are not going to want to dive into the market without first doing their homework, particularly as there are likely to be cheaper comparable companies elsewhere. QFIIs are, therefore, likely to want to do site visits and carry out extensive due diligence on companies before investing.

This means their targets will increasingly become exposed to and will have to become more familiar with this kind of exercise and other international practices if they want to attract international institutional investment. These domestic PRC companies will also have to overcome some of the traditional reservations about disclosing corporate information to outsiders. From a PRC company's angle, the obvious benefit of the QFII scheme is the "halo" effect of having one of the world's leading financial institutions as a shareholder.

A sign of continuity of reform and opening up under the new Chinese leadership;

The timing of the release of the QFII Tentative Procedures on the eve of the opening of the 16th Chinese Communist Party Congress in Beijing, which will see the hand over of power to the so-called "fourth generation" of leaders is unlikely to be pure coincidence. It was perhaps intended to convey the message that the policies of reform and opening up to foreign investment are set to continue, notwithstanding the far-reaching changes in the Chinese leadership over the coming months.

It is notable that the introduction of the QFII scheme is a policy decision which takes China further down the road to securities market liberalisation, but that the changes brought about by the QFII Tentative Procedures are not driven by specific WTO commitments and liberalisation deadlines. This should be read as a positive sign.

Part of a wider movement to reform the PRC securities market.

The QFII Tentative Procedures should not be seen as a standalone piece of legislation, but as part of a wider set of reforms of the PRC securities markets. In recent weeks, CSRC has issued a flurry of important new regulations including: Notice on Transfer of State Shares and Legal Person Shares in Listed Companies to Foreign Investors[1] (lifting the 1995 moratorium on foreign investors purchasing unlisted State-owned Shares and Legal Person Shares of listed PRC companies), the Administrative Procedures for the Acquisition of Listed Companies[2] (which set out ground rules for acquisition of controlling interests in listed companies) as well as the Tentative Regulations on the Use of Foreign Investment to Restructure State-owned Enterprises[3].

It is encouraging to see that China is making such rapid progress towards opening up the domestic market to foreign investment and, at the same time, towards bringing its regulatory framework into line with international norms on merger and acquisitions and public takeovers.

[1] Jointly issued by the Ministry of Finance ("MOF"), CSRC and the State Economic and Trade Commission ("SETC") and effective 1 November 2002.

[2]Issued by CSRC and effective 1 December 2002

[3]Issued by SETC, MOF, the State Administration of Industry and Commerce and the State Administration of Foreign Exchange and effective 1 January 2003

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