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Wooing home offshore renminbi
THE plan is this: Starting with Hong Kong, yuan-denominated deposits held offshore are channeled into mainland equities, thereby further opening up China's long-isolated capital market and – with any luck – stanching the ugly losses suffered by its key equity gauges.
With major deregulation looming, market observers are now actively speculating how big a boost such a program might give to A shares in the Year of Dragon. But under the proposed scenario, this latest market innovation may lack enough firepower to energize sluggish mainland stocks in the short term.
China's central bank last week issued guidelines for the Renminbi Qualified Foreign Institutional Investors, or RQFII, program in preparation for the backflow of yuan funds in Hong Kong into mainland equities.
The RQFII program will complement the existing Qualified Foreign Institutional Investor, or QFII, project, which lets overseas institutions convert foreign currencies into renminbi and trade yuan-denominated equities in Shanghai and Shenzhen.
Just like the QFII scheme, institutions wanting to participate in RQFII will be required to apply for investment quotas. The initial size of the fund pool is set at 20 billion yuan (US$3.17 billion), but analysts say that could rise to US$15 billion in coming years. The overall QFII quota currently stands at US$30 billion.
About 20 Chinese mainland brokers and funds that have Hong Kong subsidiaries already had gotten the green light from the China Securities Regulatory Commission for a trial run in the first quarter of this year. They would issue renminbi-backed funds in Hong Kong to both institutions and individuals.
The initiative has two major underlying purposes.
The first is to boost the international status of the Chinese currency. It's no secret that the Chinese central government hopes to promote international use of the renminbi and thereby reduce its reliance on US dollars in trade settlements. To this end, the State Council, China's cabinet, has already extended a pilot program nationwide, allowing cross-border transactions to be conducted in yuan.
The second purpose of the RQFII program is to shore up liquidity in the mainland equity market, or at least provide the framework for it. It is interesting to note that regulators launched RQFII in tandem with a slump in mainland shares and lukewarm trading volume.
The Shanghai Composite Index was down nearly a quarter last year, making it one of the world's worst-performing indexes. The losses were tied to worries about government credit tightening and an economic slowdown. Still, rampant fundraising by large listed companies, lingering austerity polices to stem inflation and brakes on property price growth may continue to weigh heavily on the mainland market.
Given these circumstances, the launch of RQFII is intended to boost investor confidence by creating a potentially big source of liquidity, while refraining from turning on the cash tap.
Many foreign firms have complained that they lack channels through which to deal with local currency derived from trade transactions. Under the new arrangement, they will be able to access the A-share market via mainland money managers.
But let's not get ahead of ourselves. Should this development come to pass, it does not necessarily mean a flood of investment in new products, despite the fact that mainland financial institutions are more familiar with the local market than their QFII counterparts.
The current arrangement for RQFII well illustrates the traditional cautiousness of Chinese regulators. Only 20 percent of the initial 20 billion yuan can be used to trade A shares, with the remainder to be invested in corporate or government bonds. Compare that with the total mainland market capitalization of 25 trillion yuan!
Let's look at the operation of the nine-year-old QFII system. Foreign investors have applied for and been granted only two-thirds the existing QFII quota, and not all of the individual quotas have been used, partly reflecting concerns about A-share volatility.
According to the China Securities Regulatory Commission, QFII funds held only 19 billion yuan worth of equities by the end of the third quarter of last year, showing a reluctance to build heavy positions in a market that has a disconnect with China's booming economy.
Back to RQFII. It may be even harder to build up overseas investors' confidence in Chinese money managers, many of whom have been involved in market-manipulation scandals in recent years and don't have consistent investment policies.
Foreign investors may also be uncomfortable with the close ties that many mainland brokerages and fund houses have with various levels of government or large state-owned enterprises. The issue is whether RQFII funds would able to operate in a truly independent, commercially driven way.
In this sense, both RQFII fund operators and investors may favor debt investment in the short term, with most of the products to be bond-focused. As the program expands, index-based products that track key mainland stock gauges may gain favor, especially among investors seeking a refuge from arbitrary investment decisions.
In the long haul, the RQFII mechanism will facilitate arbitrage activities between the mainland and Hong Kong markets, further narrowing the valuation gap. Due to the heavy slump in A-shares, many mainland-listed banks and other heavyweights are now trading at a discount to their Hong Kong-listed counterparts.
There is, however, still a long way to go before China's capital market is opened fully to foreign participation.
We can't expect regulators to abolish the quota systems for QFII or RQFII anytime soon. The maturity of the market ultimately will depend on currency convertibility. Only then will China enjoy a prominent position in the portfolios of overseas investors.