The annoucement that China’s securities regulator had lifted the investment quotas for both qualified foreign institutional investors (QFIIs) and renminbi-QFIIs is good news. The immediate ramifications may be small, but it could pave the way for a more pronounced shift in investment culture.
In essence, the 292 approved foreign investors, which include fund management companies and asset owners, can now invest as much money as they wish into China’s equity and bond markets.
That sounds like a big shift in policy, but in fact it’s more like a commitment. The truth is that since the opening of the Stock Connect programmes between Hong Kong and Shanghai and Shenzhen, in 2014 and 2016, respectively, the quotas have become less important – although they still encompass a broader variety of instruments than the Connect alternatives.
The overall appeal of China’s local markets with foreign investors has also been less than compelling of late. Last year the pronounced volatility in the Chinese stock markets soured sentiment; this year, even though the Shanghai Composite index is up 22.68% year-to-date, rebounding from its rout in the fourth quarter of 2018, investors have been concerned about the impact of the protracted trade war with the US on China’s stock performance.
US fund managers and asset owners in particular have been leery about visibly investing more in Chinese assets at a time when the country is in the middle of a trade dispute. None of them want to be on the receiving end of the US president’s itchy Twitter fingers.
But this reform is likely to outlast these immediate concerns. In essence, Beijing is further edging open the door to its capital markets, hoping that more investors will accept the invitation.
It makes sense that they do so. Index providers, led by MSCI, have started to add A-shares to their global benchmarks. To ease investors in, to date they have only added a small proportion of the market cap of leading Chinese companies, but those proportions will rise over the next couple of years.
Similarly, bond indexes are beginning to introduce renminbi debt into their benchmarks. On September 4 news broke that JP Morgan intends to add onshore Chinese bonds to its widely followed indexes.
That process both encourages and forces international investors to access some of the shares, and means that they will have to do so in rising volumes. Having unlimited QFII quotas will make that process easier for those that have already been approved or gain permission in the future.
For now, fund houses look content to access A-shares and renminbi bonds in a relatively limited fashion. But, Trump tirades or not, they will have little choice but to add to their allocations as the benchmarks that they use to do so.
Given this need, it makes sense for them to have fewer restrictions – and easing the rules also encourages the index providers to raise the thresholds of China weightings more rapidly.
There are, to be sure, more questions that still need to be addressed. Beijing has had an unwelcome willingness to tamper with its markets when they experience sudden drops, while US anger over intellectual property theft is based on very real examples.
China needs to do a lot of work to encourage better corporate governance and the status and integrity of onshore research, particularly in its credit ratings sector. It is welcome news, however, that Standard & Poor’s gained a local licence in January, and has started to rate local bonds. Moody’s and Fitch Ratings should also be granted such licences, to encourage friendly competition. And, as we have previously argued, Beijing should allow bankruptcies where necessary, to demonstrate that real risk exists and to remove so-called moral hazard.
Building credibility with international investors will be essential if China is to attract more capital flows. And it needs to do so if it is to keep funding its companies, rather than continuously leaning on state banks that prefer to lend to other public sector companies.
More foreign investment in China might begin to do what trade has thus far failed to manage, by rewarding local firms that raise their governance standards with steady investor support, while punishing those businesses that lack ethical or professional standards by locking them out of international capital.
That sort of investor influence may seem a stretch today, but the ability of foreign investors to promote professional stewardship and investor expectations shouldn't be underestimated. China will need to welcome more foreign capital as its current account slips into a deficit, and that will give them some ability to influence how local companies act.
Ideally, foreign companies would enter with a genuine focus on environmental, social and governance standards (ESG), both to pick out likely winners and to conduct a basic level of risk management. The ‘governance’ part will be particularly crucial in a country noted for corruption.
It will likely take years, even decades, for China’s investment culture to evolve to international standards. But opening up its markets to more professional investors is a welcome start. And the entrance of offshore capital – hopefully with ESG strings attached – could yet persuade some Chinese companies to pull back from some of the behaviour that threats and tariff-rattling have thus far failed to achieve.
To discover the opportunities related to China’s bond markets, please join us at the China Fixed Income Summit in Hong Kong on September 26th