Opening doors

China’s capital markets are set to become deeper and more transparent as regulators allow more foreign investors to purchase domestic securities.

China is opening its domestic capital markets to a widening group of foreign investors as it seeks to unlock its capital account and expand the use of the renminbi.

The total amount of foreign investment permitted remains relatively small at Rmb1trn (US$161.5bn), compared with the Rmb60trn outstanding in China’s capital markets, and the arrival of more overseas participants is expected to result in greater transparency and sophistication.

“The gradual increase in these programmes’ quotas will partially remove barriers and reduce market segmentation,” said Emir Hrnjic, director of education at the National University of Singapore Business School’s Centre for Asset Management Research and Investments.

“This, in turn, will likely increase liquidity (most obviously via a decrease in bid-ask spreads) and improve price discovery in the market. The gradual opening of the market to global players certainly is the right thing to do. Currently, China’s economy is over-reliant on domestic banks.”

For investors, access to China’s markets cannot come soon enough. The country’s onshore bond market stands at Rmb30trn, more than 40 times the Rmb730bn outstanding in the offshore renminbi, or Dim Sum bond, market. The domestic market not only offers better liquidity, but higher yields.

“The main driver for investors to invest through the [renminbi qualified foreign institutional investor] programme on the fixed-income market is the yield pick-up over offshore Dim Sum bonds, although the gap has narrowed to less than 1% this year due to better liquidity conditions onshore,” said Patrick Wong, head of China sales and business development at HSBC Securities Services.

“The gradual opening of the market to global players certainly is the right thing to do. Currently, China’s economy is over-reliant on domestic banks.”

Yields on the long-end largely had converged between similar-tenor onshore and offshore bonds, but, in the short end, there was still a spread differential of about 130bp–140bp, said Becky Liu, senior rates strategist at StanChart.

Foreign investors can buy domestic Chinese securities through the renminbi qualified foreign institutional investor programme, or RQFII, the qualified foreign institutional investors programme, or QFII, and the interbank bond programme.

The aggregate quota approved for the three programmes exceeded Rmb1trn as at the end of 2013, already larger than the entire offshore Dim Sum bond market, according to data from StanChart.

The programmes, however, restrict who can invest and how much. QFII, which started in 2002, allows investors to buy Chinese securities with foreign currency, US dollars converted to renminbi to be invested onshore. The RQFII programme, begun in 2011, allows investors to buy stocks and bonds with offshore renminbi.

The interbank bond programme, set up in 2010, gives foreign investors direct access to the APRC’s onshore interbank bond market within a People’s Bank of China-assigned quota. As of last November, the quota stood at about Rmb600bn, assigned to 138 investors, according to the central bank.

The programme offered the most flexibility, but was limited to six types of foreign investors, namely foreign central banks, sovereign wealth funds, renminbi clearing banks, renminbi settlement banks, supra-nationals and insurance companies, StanChart analysts said in a June report.

The interbank bond market in China handles 96% of daily trading volumes.

“This programme is likely to expand very fast as more renminbi-clearing banks would want to join,” said Liu at StanChart.

RQFII versus QFII

RQFII is the programme with the most momentum as China continues to expand its availability to more cities. South Korea and Germany are recent additions with new Rmb80bn quotas each. Other cities with approved RQFII quotas are Taiwan, Singapore, London and Paris, and Hong Kong, which has the biggest quota of Rmb270bn.

As of June 30, China approved Rmb250bn in investments under the RQFII programme to be allocated among 71 institutions, up from Rmb70bn in January 2013. About 58% of the approved amount went to asset managers and 18.4% to securities companies, according to data from State Administration of Foreign Exchange.

The QFII quota now stands at US$150bn. Of that, about US$56.5bn was approved for 252 financial institutions. In the last two years, regulators have lowered entry requirements to qualify for the programme and have simplified the application processes.

Investors like the RQFII programme more because it allows daily trades and redemptions and sets no limit on asset allocations. QFII investors are limited to a 50% allocation to stocks.

“RQFII is very popular among foreign investors because it is the first China access scheme that allows daily liquidity, which is key from an asset management company’s perspective,” said HSBC’s Wong.

As QFII allowed weekly and monthly liquidities, depending on the category, investors faced heavy haircuts when they pledged assets to get credit, Wong said.

“RQFII is a programme tailor-made for asset managers,” he said. “It caters to investors with offshore renminbi and allows two-way transmission of the currency.”

A previous requirement that RQFII investors needed to invest at least 80% of their quota in interbank bonds was scrapped in March 2013, leaving investors free to choose between fixed-income and equity investments.

As such, funds in newly established renminbi centres have rushed to apply for RQFII licences.

In Singapore, Fullerton Fund Management, APS Asset Management and Nikko Asset Management Singapore have obtained RQFII licences in recent months. In London, Ashmore Group, HSBC Global Asset Management UK and Blackrock UK have been granted licences. Typically, funds apply for licences from the China Securities Regulatory Commission and then they seek quotas from SAFE.

Offshore renminbi assets, including deposits, CDs, bonds and loans, reached Rmb2.2trn in March and are expected to exceed Rmb2.5trn as of the end of the year, according to StanChart. In Hong Kong alone, renminbi assets amounted to Rmb893.4bn.

Domestic diversity

Aside from higher yields and greater liquidity, investors are attracted to China’s onshore bond market for its broad range of investments.

On the list of investments are policy bank bonds, central bank bills, financial bonds, commercial bank subordinated bonds and hybrid capital bonds, commercial paper, medium-term notes, asset-backed securities, listed companies bonds, local government bonds, international development institution bonds, small-and-medium enterprise collective notes and private placement notes, according to a March HSBC research report.

Still, government-backed credits dominate the onshore bond market, representing 75.5% of China’s outstanding bonds. Specifically, 29.1% of outstanding bonds were treasury bonds and then financial bonds, which policy banks and state-owned banks mainly issue, accounting for 28.9% as of December 2013, according to data from China Bond website, the PRC’s national bond registration platform.

Generally, foreign investors liked paper that they considered safe, such as central government bonds, which yielded 3% 5%, and policy bank bonds, which offered slightly more of a yield pick-up, said Rex Chan, head of QFII and RQFII sales at Industrial Bank.

For instance, QFIIs and RQFII investors bought a good chunk of China Development Bank’s Rmb6bn 4.97% two-year and Rmb2bn 5.28% five-year bonds sold last March. Investors from the two programmes, together with a few foreign banks, bought a third of the paper.

Asset managers in joint ventures with local funds had higher risk appetites, Chan said. Funds, such as JF Asset Management and PineBridge Investments, all had onshore JVs and they tended to invest in high-yield bonds, such as those from local government funding vehicles, he pointed out.

“This is because their onshore partners are more familiar with the Chinese market and, therefore, have better risk control,” he said.

As of February 18, more than 100 foreign institutions invested in the interbank bond market. These includes central banks, international financial institutions, sovereign funds, clearing banks in Hong Kong and Macau, and insurance companies, QFIIs and RQFIIs, according to the HSBC research report.

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