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Pacific Perspective "Victor" Wei Huang |
China’s stock market opens
to outsiders, with obstaclesOn July 9, UBS AG, a Swiss-based financial group, made history by buying stocks in China's domestic A-share market under a new investment scheme dubbed "qualified foreign institutional investor" (QFII). The transaction, albeit involving only four stocks, marked the first time a foreign institution had been able to invest in China's domestic equity markets.
China launched two stock exchanges -- the Shanghai Stock Exchange in 1990 and the Shenzhen Stock Exchange in 1991 -- as part of an effort to build a more market-oriented economy. Since their inception, the Chinese stock markets have grown at a phenomenal pace. The number of listed stocks has increased from 13 in 1991 to nearly 1,300 and aggregate market capitalization has risen from less than $1 billion to nearly $500 billion over the same period. Combined, China's stock markets are the second largest in the Asia-Pacific region after Japan.
Despite the rapid integration of China's economy into the world system, especially in the areas of trade and foreign direct investment, the Chinese stock markets have remained effectively isolated. Foreigners were legally prohibited from buying domestic A-shares; which were designated specifically for local residents. Conversely, locals could neither purchase Chinese offshore shares, nor invest in foreign securities due to China's foreign exchange and capital account restrictions. Only about 10 percent of Chinese listed companies issued offshore shares -- in the forms of B-, H-, and N-shares denominated in either U.S. dollars or Hong Kong currency -- that could be purchased by foreign investors.
Reflecting Beijing's determination to eventually integrate its financial system into the global market, China introduced in December 2002 a system that allows selected foreign institutional investors to convert foreign currency into Chinese currency and invest it in the domestic A-share market. So far, five investment banks -- UBS, Morgan Stanley, Nomura Holdings, Goldman Sachs and Citigroup -- have received approvals to invest in A-shares through the QFII system. More banks such as ING, HSBC and Deutsche Bank are lining up for applications.
In the long term, the inflow of foreign funds into China's domestic equity markets is expected to have a profound impact. In the short term, China's domestic stocks will likely join the Morgan Stanley Capital International emerging market index family and as a result A-shares will likely be added to the global investable indices. Value oriented investment from experienced and prudent foreign institutional investors will enhance the efficiency of capital allocation in China through equity trading and will help to raise the standards of corporate governance. Foreign institutional investors will also provide a stabilizing force to the otherwise volatile, retail investor dominated equity market.
The full impact of these changes may not be seen any time soon. Analysts estimate that up to $10 billion in investment funds may be needed to have a measurable effect on an equity market the size of China's. The inflow of funds has so far fallen far short of that amount. This is due to a number of obstacles hampering the inflow of foreign capital such as the stringent investment quotas imposed on QFII. The five investment banks approved under the QFII have been awarded a total investment quota of about $700 million. UBS, while it was awarded a $300 million quota, may take months or longer to reach its investment ceiling. In addition, the number of potential QFII members is limited due to a lofty minimum asset threshold. To join the QFII club, the institutional investor must have had a minimum of U.S. $10 billion in assets under management in their previous financial year. In addition, fund management companies must have had at least five years of operational experience while insurance companies must have had 30 years of experience and paid-in capital of at least $1 billion.
There are other constraints hindering increased investment under the QFII program. For example, to prevent "hot" money escaping from China and triggering a financial crisis, the current QFII system requires funds to be held onshore for at least one year before being repatriated, although investors can sell their stocks at any time. Some chronic problems embedded in the Chinese stock market, such as inadequate disclosure, ineffectual regulatory supervision, an opaque legal and governance framework, price manipulation and rampant speculation, may also hamper the progress of the inflow of QFII funds. Also, the change of valuation of the Chinese currency, regardless of direction, is another uncertainty potentially hindering the foreign investment in China's stock markets. If the Chinese Renminbi appreciates, as demanded by the United States and other trading partners, it will increase the cost of investing for prospective QFII, as they will need to convert foreign currencies into the Chinese currency. Alternatively, if the Chinese government has to print money to fix some of its financial problems, such as the nonperforming loans in the state owned banking system and an underfunded government pension and healthcare liabilities, the currency may devalue significantly, and destabilize the economy.
"Victor" Wei Huang teaches in the department of financial economics and institutions at the University of Hawaii at Manoa College of Business Administration. reach him at whuang@cba.hawaii.edu.
