China recently took another step toward opening its financial market when the State Administration of Foreign Exchange (SAFE) removed investment quotas for two trading programs that allow overseas institutional investors to invest into China’s capital market. The Qualified Foreign Institutional Investors (QFII) and Renminbi Qualified Foreign Institutional Investors (RQFII) were implemented in 2002 and 2011 respectively to allow foreign investors to enter China’s capital market directly. Now, in a move to simplify that access and promote these channels for inbound investment and growth, they’re dropping investment quota restrictions. This follows a consultation issued earlier this year by the China Securities Regulatory Commission (CSRC) to merge the QFII and RQFII programs as well as relax certain existing requirements related to investor qualification and investment scope.
What we know
The qualified foreign investor system is one of the main channels for foreign investors to invest in domestic financial markets in China. Earlier this year, SAFE increased the number of available licenses for QFII and RQFII, which also allowed for more investment into the market.
In addition to dropping the investment quota, SAFE also eliminated the restrictions on repatriation and removed the relevant lock-up period requirements. Qualified foreign investors can carry out foreign exchange hedging onshore, which facilitates foreign investors to invest in China’s onshore financial markets. These moves indicate the wider Chinese policy shift towards allowing freer flows of capital between Mainland China and the rest of the world.
They also removed the RQFII quota of pilot countries and regions, which included 20 markets like Hong Kong and Japan. Eligible foreign investors around the world are now welcome to use offshore Renminbi (RMB) to conduct onshore securities investment in China.
SAFE will consult the industry on the finer details before finalizing their implementation plan to remove the QFII and RQFII quotas. We expect further details to be announced before the end of the year.
Global investors increasing allocation to China
The inclusion of China investments into global flagship equity and bond indices has continued to pick up pace this year. For equities, MSCI recently completed their second phase of a three-step process to include A-shares. The inclusion factor increased to 15 percent and A-shares now account for 2.5 percent of the MSCI Emerging Market Index. FTSE Russell began the process to include China equities in their benchmarks in June of this year, while S&P also recently announced that they will add A-shares to the S&P Emerging BMI later this month.
On the bond side, Bloomberg began a 20-month inclusion process in April to add Chinese government bonds and policy bank notes to the Bloomberg-Barclays Global Aggregate Index. JPMorgan recently followed suit, with an announcement that they will begin a phased inclusion of Chinese government bonds into their indices beginning in February 2020. Analysts expect that passive reallocations alone for Bloomberg and JPMorgan will create $175 billion of inflows into China bonds.
As a result, asset managers tracking these indices will want to begin to allocate to China otherwise they may risk introducing tracking error for their portfolios. With an increase in foreign investors buying Chinese investments, it is worth noting that access is becoming more efficient with developments like the SAFE plan to remove QFII and RQFII quotas. However, our 2019 Greater China Survey indicates that over 50% of US and European institutional investors plan to use exchange traded funds (ETFs) as their access channel when increasing their exposure to China this year.
Growth of passive investing in China
Growth in the China domestic fund industry has been dominated by mutual funds until 2018. However, in 2018, matching trends in other global fund centers, assets in China domiciled ETFs grew by 72% while the mutual fund industry grew by just 12%, decreasing from 30% in 2017. China has grown to the second largest ETF market in Asia with $67 billion in assets under management, which is only behind Japan. Assets have increased 39% YTD through August and even though ETFs have a short history in China, they have been gaining traction, mirroring many of the ETF trends we see globally.
Asset allocation is still a relatively new concept for Mainland investors where 86% of the China A-Share turnover in 2018 was from retail investors. Even though retail investors dominate the equity market, cost is an increasingly important consideration for institutional investors in China where ETFs have historically average management fees of 50 bps. As the efficiency of the China market continues to improve, it will become more challenging for active managers to outperform their benchmarks.
As outlined in the BBH 2019 Greater China ETF Investor Survey, 77% of Chinese institutions expect to increase their allocations to ETFs in 2019, which was an increase from 43% in 2018. The flows substantiate that statistic and with continued structural reform, we believe ETFs are well positioned to capitalize on the growth.
Path to China domestic funds business
Another development for global asset managers to continue to keep an eye on is the ability for wholly foreign owned enterprises (WFOE) in China with private fund management (PFM) licenses to convert to a public fund management company. More than 40 global asset managers have set-up WFOEs in China, but currently via the PFM license, they are limited to only structuring private funds for qualified investors. The ability to have a 100 percent foreign owned fund management company will be a significant increase in access to the domestic market where assets are expected to triple by 2025 to $14 trillion.
More to come
As Chinese regulators continue to promote inbound capital flow through the relaxation of regulatory and foreign exchange requirements for the existing inbound channels, many asset managers are also actively watching if there will be increases in quota for the outbound programs like the Qualified Domestic Institutional Investor (QDII), which facilitates domestic funds in China to invest into global markets. Currently 152 license holders have received a total of $104 billion of QDII quota since the inception of the program.
There is no shortage of developments in Greater China as regulators and other policymakers continue to provide increased market access for foreign investors while accelerating the opening of the capital markets in China. We expect this trend to only continue.
This article was written by BBH Senior Vice President Chris Pigott. Chris is the Head of Hong Kong ETF Services and responsible for ETF business development in Hong Kong. In addition, he manages Investor Services relationships throughout Asia.
 Bloomberg, JPMorgan
 BBH Greater China ETF Survey – 2019
 Oliver Wyman – China AM – ETF as next wave of growth
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