Over the last few years, the Stock Connect program replaced QFII as the main access route for onshore Chinese equities. However, the China Securities Regulatory Commission recently released a consultation paper seeking feedback on a proposal to drastically simplify and enhance the QFII program. How is this likely to evolve over time?
A few decades ago, foreign investors were unable to access the Chinese onshore equity markets. In 2002, the Chinese authorities launched the Qualified Foreign Institutional Investor (QFII) program as a way to provide limited and controlled access. Getting a QFII license was a restrictive, lengthy and time consuming process requiring the applicants to meet certain standards of financial stability and track record. The program was subject to strict quotas and more importantly, approvals were subject to Government discretion. The program evolved significantly over time and by the end of 2018, an aggregate quota of $101B had been granted to 309 institutions.
The Launch of the Stock Connect
Despite being the second largest equity market in the world, Chinese onshore equities were not included in broad indices because of this limited accessibility and the restrictions accompanying the QFII program. In a step towards changing this, in Dec 2014, China established a new mechanism to allow foreign investors to invest in Shanghai listed equities via Hong Kong, commonly called the ‘Stock Connect’ program. This program offered several benefits compared to the QFII- ease of registration, no specific requirements for AUM or track record, daily liquidity etc. After a lukewarm initial response, the Connect program took off in 2015/2016. In December 2016, the program was expanded to include Shenzhen listed stocks, including stocks listed on the ChiNext board.
Over 2017 and 2018, the Connect program grew in depth and breadth, replacing QFII as the main access point for China. MSCI decided to include Chinese equities in its indices, starting in 2018 and most passive investors used the Connect route to build positions in Chinese stocks. Consensus views called for the ‘death of QFII’ and many institutions returned or scaled down their QFII quotas.
The Revival of QFII?
However, behind the scenes there was significant lobbying by onshore brokerage firms to revive the QFII. The Connect is dominated by global brokers serving foreign clients through Hong Kong. The revenues from the Connect are shared between China and HKEx. As a result, the major beneficiaries (from a revenue standpoint) have been the foreign brokers and HKEx. Further, the CSRC had more control, visibility and transparency including end client identification with QFII. The Chinese authorities as well as the local financial firms are aligned in their interest to revive the QFII program. With this goal in mind, the last few years have witnessed easing of several restrictions on the QFII including the removal of the 20% cap on outbound remittances, removal of principal lock up period, and allowing foreign exchange hedging.
Looking back, it is easy to spot signs of convergence between the QFII and Connect schemes. In line with the Connect, the QFII program now has better liquidity, less restrictions (no locks up, large quotas) and clear tax rules. And in line with the QFII, the Connect now has access to a wider range of instruments as well as a clear ID system allowing the authorities to track end investors.
The latest development in the QFII program came earlier this year, when the CSRC released a consultation paper simplifying the program significantly. The proposed measures would bringing the QFII mechanism even closer to the Connect and add some new features as well. Highlights include no more AUM/years of experience requirements for a QFII application, streaming the process from an approval to a registration based process, expansion of the QFII investment universe and allowing QFII holders to participate in the onshore lending market. While these are still proposals and more details are needed, the moves indicate a substantial easing of the operations, regulatory and investment process.
Many institutional investors have asked us how we see these schemes evolving. We believe these schemes will continue to converge and at some point will be virtually indistinguishable. The key outstanding issues will revolve around
- Will the QFII process get simplified to a point where MSCI will accept this as the main point of access? There are other markets e.g. Taiwan and Korea where this is an accepted way of accessing the market
- Can foreigners get comfortable with the governance issues or will they still prefer a Hong Kong based route since HK still has the advantage (perception) of “rule of law”?
We see Connect as being the dominant mechanism in the near future with growing convergence between the QFII and Connect. The latest proposal from the CSRC signifies the intent of the authorities to make the QFII process easier and to eventually have this as the mainstay. Like most things in China, this evolution will be driven by the intent of the Chinese Government as well their flexibility and pace of change.