China: The impact of market volatility on liberalisation

CHINA THE IMPACT OF MARKET VOLATILITY ON LIBERALISATION

INTRODUCTION It would not be an exaggeration to claim

the other various quota schemes, will

that China is the number one worry on

be hotly debated during the upcoming

the minds of investment management

FundForum Asia conference taking

professionals at present.

place in Hong Kong from 18-21 April.

Whether you are active in developed

This report provides a snapshot of

markets, emerging markets, pan-Asia

the current situation, but given the

or very niche frontier, the ripples of the

speed at which the environment

Chinese slowdown are being felt, and

evolves, I would like to draw your

debated globally.

attention to China Summit on Monday 18 April at FundForum Asia which

It should therefore come as no surprise

will provide you with expert, granular,

that these issues, from the macro-

and up to date insights.

economic and the political to the business and product-centric topics

Sarah Armstrong

around Mutual Recognition, QFII and

FundForum Asia Editor-in-Chief

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WHAT IS HAPPENING?

The introduction of a circuit breaker system in December 2015, a mechanism by which to force a cessation of

Market volatility in China has been

trading activities during exceptionally

rampant since summer 2015. On one

choppy markets, failed spectacularly

day alone in June 2015, the Chinese

to stem volatility in January 2016. The

listed equity market nursed value

threshold on the circuit breakers, which

losses in excess of $700 billion.

was set at 5% (well below that of other

Predictions of a hard-landing in China

established markets) was criticised

have been popular for many years now

for being too narrow particularly given

and numerous commentators believe

the lack of available stocks to trade

that this market correction is now fully

in China. As such, these were duly

in train. The factors behind the summer

suspended as they naturally caused

volatility are well-documented.

panic selling among investors.

Chinese equity markets are

Other methods to stem volatility have

predominantly retail-driven, with

been implemented. The forced buying

ordinary investors accounting for

by the so-called “National Team” –

approximately 80% to 90% of trading

a collective of government-backed

activity. The volatility was exacerbated

financial institutions has bought some

by the prolific use of margin finance –

temporary relief. However, share sales

i.e. using leverage and heavy borrowing

remain restricted for those investors

when trading. This liberal use of

owning in excess of 5% of tradable

leverage ultimately amplified losses

shares and a shorting ban continues

when a correction occurred. Regulatory

to be in place.

efforts to reduce margin finance activity predictability led to panic among retail

The People’s Bank of China (PBOC) has

investors and subsequent quick-fire

also been purchasing offshore RMB

selling depressing prices ever further.

to close the gap between onshore and

Attempts by regulators to stem volatility

offshore rates. PBOC has also attempted

have included suspensions of Initial

to stave downward pressure on the RMB

Public Offerings (IPOs), prohibitions on

by obliging foreign banks trading

share trading and short-selling bans.

RMB offshore to place reserves with

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The volatility in China has had regional

The extent of China’s intervention in its capital markets should not be underestimated.

Data indicates China slashed its reserves by nearly $180 billion in the three months leading up to September 2015 bringing the total decline to $480 billion.

and global ramifications. Stock markets including the Dow Jones have fallen while the declining appetite for oil and commodities in China is prolonging the oil price rout and downturn in emerging markets, particularly in Africa and Latin America. Simultaneously, the economic turbulence could also have an impact on Chinese market liberalisation, which has been a hot topic of conversation at countless industry events.

China has gradually been liberalising

the Central Bank. Some view this

its markets over the last decade,

as a warning against traders betting

making it easier for foreign investors

on a quick depreciation of the RMB.

to acquire listed securities, and even for fund managers to solicit and raise

The extent of China’s intervention

capital from domestic retail investors.

in its capital markets should not be

There has been a huge amount of

underestimated. Data indicates China

excitement around these changes, but

slashed its reserves by nearly $180

how has all of this volatility affected

billion in the three months leading up

the liberalisation of China’s capital

to September 2015 bringing the total

markets?

decline to $480 billion. Nonetheless, China still has holdings estimated to be $3.5 trillion.

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QFII

investor appetite. SAFE data indicates that January 2016 witnessed a drop in QFII quota allocations by $30 million

One of the reasons why QFII is being liberalised is to harmonise it with RQFII, which foreign investors tend to find more usable and investor friendly.

from December 2015, bringing the total quotas provided to foreign financial institutions to just over $81 billion. This comes as the Shanghai Composite Index has fallen quite significantly since the year began.

Reports in the Financial Times also indicate that SAFE in Beijing is

The Qualified Foreign Institutional

encouraging institutional investors

Investor (QFII) scheme has been

to apply for greater QFII quotas. This

a feature of Chinese capital markets

is part of the government’s efforts

for over a decade. QFII permits foreign

to mitigate further capital flight by

investors to invest a finite amount

facilitating inflows from foreign

of capital into the country.

investors. Estimates of capital outflows

QFII quotas have been allocated

from China are varied with different

somewhat sparingly since inception.

sources putting it at between $150

Recently though, a handful of countries

billion and $400 billion.

enjoyed increases to their quotas.

Meanwhile, the Renminbi Qualified

“One of the reasons why QFII is being

Foreign Institutional Investor (RQFII)

liberalised is to harmonise it with

scheme has also been extended

RQFII, which foreign investors tend to

through increased quotas courtesy

find more usable and investor friendly.

of the State Administrative of Foreign

Harmonising the rules will ease the

Exchange (SAFE).

administrative burden for domestic Chinese regulators,” said Florence

Beneficiaries include Switzerland,

Lee, head of China sales and business

the UK, Korea, Germany, France and

development for EMEA at HSBC

Singapore. However, the market

Securities Services.

volatility has dampened foreign

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China has gradually been liberalising its markets over the last decade, making it easier for foreign investors to acquire listed securities, and even for fund managers to solicit and raise capital from domestic retail investors. There has been a huge amount of excitement around these changes, but how has all of this volatility affected the liberalisation of China’s capital markets?

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STOCK CONNECT

UCITS strategies. Fortunately, the global custodian banks recognised these limitations and have since launched

Stock Connect (“Hong Kong-Shanghai

structural mechanisms to overcome

Stock Connect�), a trading scheme

these divergences in trade settlement

connecting the stock exchange of

times between Shanghai and Hong

Hong Kong with that of Shanghai, was

Kong. This has included the creation

unveiled to much fanfare in November

of Special Segregation Account models,

2014. The project was designed to

for example.

facilitate investment into Chinese A shares by investors with Hong Kong

Since these developments at global

brokerage accounts, and investment

custodians, a growing number of

into Hong Kong by Chinese investors.

managers have sought to invest in Chinese A shares. It has also been

Initial trading volumes were somewhat

given regulatory sanction. In summer

disappointing due to foreign investor

2015, the Central Bank of Ireland (CBI)

concern about prefunding and issues

confirmed UCITS could now invest

over trade settlement. The biggest

through Stock Connect although

impediment initially was that China

approval would be granted individually

utilised a T+1 trade settlement time-

by the regulator. The Commission de

frame for cash and T+0 trade settlement

Surveillance du Secteur Financier

for securities. This conflicted with

(CSSF) in Luxembourg also granted

Hong Kong which operated a T+2

similar approval to its UCITS. While

settlement time-frame for cash and

settlement risk was originally the

a T+2 settlement time-frame for

biggest challenge, the market volatility

securities. This meant any investor

has raised alarm bells at some law firms

transferring securities to China would

with close dealings with UCITS.

be left waiting a day before their cash Nowadays, the biggest concern is for

was reciprocated.

managers who have exposure to shares This counterparty risk was

which are currently delisted or unable

unacceptable to a number of investors,

to be sold because of government

particularly fund managers deploying

share sale suspensions. This obviously

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liability for loss of assets or financial instruments by depositary banks to

There was widespread belief that Shenzhen’s stock exchange would also benefit from a Stock Connect scheme similar to that of Hong Kong and Shanghai. Shenzhen’s stock exchange, which predominantly lists small to mid-cap companies, is expected to have its own Stock Connect unveiled in 2016 although precise dates are yet unknown.

any sub-custodian including central securities depositories (CSDs) and central counterparty clearing houses (CCPs). As such, certain risk-averse depositary banks (which are tasked with asset safe-keeping) may become increasingly nervous about UCITS with exposure to China. They may ramp up depositary fees for China-focused UCITS managers when UCITS V comes into being in March 2016.

Investor flight, however, is beginning

presents a liquidity issue for UCITS,

to show through Stock Connect.

many of whom offer daily or weekly

When the scheme was first created,

redemption terms to retail clients.

many assumed capital inflows would

Furthermore, striking an accurate Net

be biased towards Chinese equities.

Asset Value (NAV) at a China-focused

However, in January 2016, figures

UCITS would be very difficult or fraught

indicated that inflows into Hong

with complications if that manager has

Kong from China via Stock Connect

underlying exposure to shares that are

surpassed inflows heading into China.

currently delisted or suspended from

The Institute of International Finance

trading. This obviously hinders their

estimates that capital outflows hit $676

accurate valuation.

billion in 2015. The outflows to Hong Kong come as a number of investors

Given these circumstances, some

struggle with the market volatility and

organisations are wary of increasing

depreciation of the RMB. Others fear

their exposure to China. The problem

that ad hoc Beijing central government

will become even more challenging

responses, which have a tendency to be

with the passage of UCITS V. UCITS

unpredictable, could further stoke the

V specifically bars the discharge of

volatility.

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There was widespread belief that

Many said the UK, which has become

Shenzhen’s stock exchange would also

a leading offshore RMB hub, ought to

benefit from a Stock Connect scheme

be a prime contender for an exchange

similar to that of Hong Kong and

linkage with Shanghai. This optimism

Shanghai. Shenzhen’s stock exchange,

was reinforced following the Chinese

which predominantly lists small to

state visit at the tail-end of 2015.

mid-cap companies, is expected to

Despite this, the likelihood of the UK

have its own Stock Connect unveiled

benefiting from a Stock Connect remain

in 2016 although precise dates are yet

slim, particularly following the market

unknown. This is, at least, according to

volatility. Excusing the market volatility

market participants speaking at NEMA

in China, there are a number of practical

Shanghai in November 2015. However,

considerations that the UK and China

given that small to mid-cap companies

would need to overcome. Firstly, the

tend to be highly volatile, it would not

time-zone difference (8 hours) would

be surprising if Shenzhen-Shanghai

make trade settlement complicated.

Stock Connect was pushed back.

Furthermore, curbs on short-selling in

Panellists at NEMA Shanghai were also

China would also be an impediment.

confident same day delivery of cash

Again, given the capital outflows to

and securities would take effect in 2016,

Hong Kong at present, a UK-Shanghai

and urged regulators to extend Stock

Stock Connect does appear to be

Connect to the fixed income, currencies

somewhat ambitious. Some regional

and commodities (FICC) markets.

(Singapore, Taiwan, Korea) stock exchanges could benefit though.

There were also suggestions that exchanges in other jurisdictions could benefit from a similar Stock Connect with Shanghai or Shenzhen.

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Most managers looking to market on the mainland will run vanilla strategies with little deviation beyond equities, bonds and potentially exchange trade funds (ETFs). In the near term, it is highly unlikely that more complex products will be permitted.

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MUTUAL RECOGNITION AND THE EMERGENCE OF HEDGE FUNDS

due diligence headache for Hong Kong managers – many of whom feared the reputational risk of being associated with a mainland firm that may lack proper risk controls or worse, be fraudulent.

Mutual Recognition (MR) – after years of speculation – came into effect in July 2015. MR permits Hong Kong-

Negating this requirement appealed

domiciled asset managers to sell

to many Hong Kong managers.

to Chinese retail while permitting

Nonetheless, the reality is less clear-

Chinese funds (of which there are

cut. Foreign fund managers operating

many) to sell into Hong Kong. Over

on a standalone basis will naturally

previous years, China has sought to

struggle to succeed on the mainland.

legitimise its burgeoning domestic

The domestic retail investors possess

funds industry. For example, it

an inherent bias towards domestic

allowed private funds – also known

managers having been shut off from

as sunshine funds - (which operate

foreign managers for many years.

hedge fund type strategies) to register

As such, foreign managers will still

with the China Securities Regulatory

probably enter into distribution

Commission (CSRC). Nonetheless, MR

agreements with large bank distributors

appears to be the big game changer.

or even online platforms in order to reach the correct target audience. These

For Hong Kong managers, it

distribution partners will invariably

represented a blessing. Traditionally,

take a commission for their work,

asset managers selling their products

although in time, it is hoped foreign

on the mainland were obliged to enter

fund managers will gain trust and

into a Joint Venture (JV) or equity

acceptance obviating the need to

partnership with a domestic securities

work in conjunction with a domestic

firm, brokerage or fund house. This

provider.

had always proved to be an operational

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Most managers looking to market on

countries for MR included Singapore,

the mainland will run vanilla strategies

Taiwan, Luxembourg and the UK, citing

with little deviation beyond equities,

the latter because of its involvement in

bonds and potentially exchange

offshore RMB.

trade funds (ETFs). In the near term, it is highly unlikely that more

However, HSBC caveated this by

complex products will be permitted.

saying the UK’s history with Hong

However, that is not to suggest this

Kong could be an impediment. Other

will not change in due course when

prospects could be Ireland and Malta,

investors and regulators become more

both of which boast strong onshore

comfortable with the higher-risk

fund regimes. Malta, for example,

products.

has positioned itself as the European onshore domicile of choice for small to mid-sized UCITS and Alternative

Many mainland investors had believed using MR was yet another way in which to get money out of China whereas under the administration system used for booking deals, this is not the case.

All redemptions as and when they may occur are paid back within China and not Hong Kong.

Investment Fund Managers (AIFMs) regulated under the Alternative Investment Fund Managers Directive (AIFMD).

Despite being enacted last year, little progress has been made on MR, predominantly because of the market volatility. In July 2015, the CSRC said 100 Hong Kong funds and 850 domestic Chinese funds qualified for MR but none had been authorised at least before

The enthusiasm is there with a number

December 2015. Given the tempestuous

of Asia-Pacific (APAC) focused banks

markets over summer, authorisations

including HSBC predicting MR could

were not forthcoming.

replicate QFII and RQFII, which were gradually extended to more and more

Nonetheless, some approvals are

third countries as time went by. A 2014

coming through albeit slowly.

HSBC white paper said viable third

“Regulators have been rather slow in

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approving products for use and the

Chinese fund managers can simply take

first round of funds were approved

their products to Hong Kong and sell

immediately before Christmas, some

without having to invest in a significant

six months after the first applications

amount of operational architecture,”

were submitted. Of those, only three

commented Lee.

were “northbound” – in other words, seeking mainland money. There are

Meanwhile, the Chinese retail market is

anecdotal reports coming out of China

strong, buoyed by an expanding middle

that the three funds have done well

class. Those firms that take the plunge

so far in raising capital but as the

initially will certainly benefit from the

aggregate size of these is only $2.6

first mover advantage. Despite this,

billion, this is hardly likely to impact

some mainland investors have used

the greater scheme of things regarding

MR as an attempt to move money out

the Chinese economy and FOREX

of China. “Many mainland investors

concerns,” said Stewart Aldcroft, CEO

had believed using MR was yet another

of Cititrust Limited, a division of Citi

way in which to get money out of China

Markets & Securities Services.

whereas under the administration system used for booking deals, this is

Nonetheless, these market

not the case. All redemptions as and

developments take time to materialise.

when they may occur are paid back

Lee of HSBC said a number of Chinese

within China and not Hong Kong,”

managers are soliciting capital from

added Aldcroft.

Hong Kong via MR. “The Hong Kong Securities and Futures Commission

Since 2013, a select group of hedge

(SFC) has approved several batches

funds have also been allowed to market

of funds submitted by southbound

to high net worth individuals (HNWIs)

managers and they are marketing to

in Shanghai under a scheme known

Hong Kong institutions and residents.

as the Qualified Domestic Limited

It is a great opportunity for China-

Partnership Programme (“QDLP”). This

domiciled managers. Many of the

scheme allows six major foreign hedge

costly and time consuming processes

funds, which included Och-Ziff, Winton,

associated with setting up in Hong

Man Group and Citadel to solicit capital

Kong have been negated, such as

from Shanghai HNWIs.

establishing a branch office. As such,

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As such, capital inflows have not excited and only a handful of the original six managers have hit the $50 million mark. In 2015, a number of large asset managers including UBS Asset Management, Deutsche Bank Asset and Wealth Management and Nomura Asset Management obtained QDLP licenses.

However, given the domestic volatility

A threshold was set with no single

and heavy losses investors have nursed

hedge fund permitted to raise more

through trading using margin financing,

than $50 million. Simultaneously, the

coupled with the negative reputation of

subscription threshold was quite high

hedge funds in Asia-Pacific (APAC) more

($500,000), particularly for a market not

broadly, it is likely inflows will not be

familiar with hedge funds.

significant over the near-term.

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MOVING TO BONDS

wealth funds. Some are bullish it could be extended to major asset managers in due course. The rule changes –

A J.P. Morgan Asset Management

announced in July 2015 – enable

paper highlighted that while most

investors to trade interest rate swaps,

investors are cognizant China is the

forward contracts and bond repos

world’s second largest economy, few

without requiring PBOC approval. All

are aware that China’s bond market

that firms are required to do now is file

is the third largest, just behind the

a straightforward, concise registration

US and Japan. Data from Goldman

form with PBOC. This easing of the

Sachs Asset Management (GSAM)

bureaucratic registration process is a

estimated the Chinese bond market

welcome development.

stood at $4.24 trillion in the first half of 2015. Others put it higher and closer

“Liberalising the interbank bond market

towards $5.7 trillion. China operates

is all part of the central government’s

an onshore and offshore bond market

long term vision to integrate the

with the latter accessible to foreign

domestic market into the international

investors. However, the J.P. Morgan

market. While the more flexible rules

Asset Management report points out

are only available to central banks,

international investors comprise just

international financial institutions and

3% of the onshore market as it can only

sovereign wealth funds, this is a good

be accessed through QFII and RQFII

start. These investors are long term and

quotas.

are not under pressure to raise capital, and it is being seen as a test run for the

As part of the authorities’ attempts

longer-term development of the market.

to internationalise the RMB, PBOC

I anticipate the reforms will gain further

announced it would introduce

ground,” said Lee.

liberalising measures to enable easier foreign investor access to the onshore

Simultaneously, there is also talk

bond market. These reforms of the

of Bond Connect, which is broadly

interbank bond market will be open to

modelled on Stock Connect. Bond

large institutional investors such as

Connect would apply to Chinese

foreign central banks and sovereign

government and corporate bonds,

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and could provide a link between the

“Most bond investors in China trade

onshore and offshore bond markets. It

via the interbank bond market. The

would also permit Chinese investors

on-exchange bond market represents

to invest in offshore Chinese bonds

a small percentage of overall bond

denominated in US Dollars, euros and

transactions in China. As such,

Japanese Yen. Last year, the authorities

both domestic and international

were moving in the right direction.

institutional investors are going to

Russia’s National Settlement Depository

predominantly trade bonds through

(NSD) and China Central Depository &

the interbank bond market in the

Clearing put in motion plans to create a

foreseeable future,” said Lee.

cross-border settlement infrastructure facilitating direct investment between

It is not rash to say that Bond Connect

each other in government bonds.

is more of a hypothetical concept than a serious policy at present. It would

Bond Connect has flaws, particularly

also not be unfair to argue that China’s

if it only applies to exchange traded

regulators – despite their efforts to

bonds, which account for a small

boost inflows to prevent a rapidly

percentage (just 3-4%) of the overall

depreciating RMB – will probably not

bond trading activity in China. The bulk

devote a huge amount of resources

of bond trading in China occurs off-

to Bond Connect just yet. If market

exchange and bilaterally meaning Bond

volatility decreases, this might change.

Connect – should the infrastructure

Nonetheless, most experts concede

to support it ever be built – would not

Bond Connect is unlikely to take effect

serve much of the bond market.

for some time.

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WHAT NEXT?

While some liberalising measures may be accelerated to stem RMB depreciation, projects like MR and the

The volatility in China is likely to

ambitious Bond Connect may simply

continue. As such, foreign investment

be put on hold for the time being.

in China is likely to slow down, as is evidenced by the outflows witnessed on

Overall, markets are volatile nearly

the Stock Connect scheme. While some

everywhere, a point made by Lee.

asset managers such as hedge funds

“Emerging markets and mature markets

through QDLP are allowed to solicit

are suffering from volatility. The UK is

capital from mainland HNWIs, inflows

even seeing pressure on the Sterling.

again will be muted as the hangover

As such, the volatility is a global issue

from losses associated

and not just a China-centric one,� said

with the equity markets continues

Lee. While the problems in China

to linger. Most importantly, the central

should not be ignored, it is abundantly

government is working to prevent RMB

obvious they are not unique to China.

depreciation and minimise volatility.

This is their priority.

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