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
2
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
3
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.
4
5
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
6
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?
7
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
8
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.
9
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.
10
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.
11
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
12
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
13
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,
14
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.
15
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,
16
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.
17
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.
18