RMB Internationalisation: Change, alignment, and maturity

China has never been more important to foreign investors and the pace of liberalisation in the country’s financial markets continues to accelerate. With MSCI’s inclusion of China A-shares into its emerging markets index and the launch of Bond Connect, we are nearing a critical point in the journey towards the complete opening of China’s financial markets to global investors.

China: A core priority

The newly released 2017 Standard Chartered RMB Investors Forum Survey, which comprised of 900 global market participants, found that 60% of respondents indicated investing in China was one of their top three priorities, while 69% planned to increase their exposures over the next 12 months. Strong GDP growth, more settled market conditions, diminished concerns about capital controls, credit market maturity, regulatory clarity and a stabilised RMB were all significant impetuses for this positive investor sentiment.

Government and sovereign entities have been increasing their investments into China, since the inclusion of the RMB into the International Monetary Fund’s Special Drawing Right (SDR) basket in 2016, in order to manage their RMB liquidity.

Liberalised FX hedging rules have attracted insurers to the domestic fixed income market. Regulatory guidelines oblige insurers to lengthen the duration of their bond holdings, forcing them to identify highly liquid, long-dated instruments which generate returns and can be hedged in the same currency. Chinese bonds fit these criteria.

Investment managers are also increasingly optimistic about China. This appetite from fund managers is primarily a result of improved market conditions, investor demand for China exposure and simplified access channels into the country’s sizeable fixed income and equity markets. More than 75% of fixed income investor respondents to the survey said volumes would increase in the next 12 months.

Identifying the correct access channel

Accessing China is not a science but an artistic skill in navigating a wide range of channels available to international institutions. In 2016, Standard Chartered predicted that Stock Connect would overtake QFII (Qualified Foreign Institutional Investor) as the most commonly used scheme for equity managers to access China.(1)

Stock Connect reforms – namely the inclusion of Shenzhen and the removal of the aggregate quota limits – have also helped drive investor interest with 40.4% of organisations saying they would grow their China investments through the scheme.

Foreign exposure to Chinese fixed income is low but this is changing under the China Interbank Bond Market reforms (CIBM). At the time of our survey in March 2017, some 12.3% of respondents said that the CIBM was their preferred access channel and over a third were evaluating CIBM as a means by which to grow their China investments. This has been enabled through FX hedging rule changes, with a number of institutions in Korea, Hong Kong and Taiwan all expressing bullish sentiment that these amendments will prompt greater flows into the CIBM market either directly or via the Bond Connect.

The emergence of new channels begs the question as to what will happen to the traditional China access routes such as QFII and RMB Qualified Foreign Institutional Investor (RQFII). Both schemes remain popular, but the survey found that just 1.9% of respondents would use QFII as an access channel moving forward, while only 50% of the quotas on average are being used by foreign investors. As the pool of foreign investors in China grows, it is likely these newer allocators will increasingly pivot towards Stock Connect and CIBM at the expense of QFII and RQFII.

In spite of the significant development of these channels, the use of offshore ‘dim sum’ bonds as a means of gaining Chinese exposure via the ‘security’ and familiarity of Hong Kong remains highly popular, with more than 17% of investors opting for this route currently. USD-denominated bonds issued by Chinese companies also present investors with the opportunity to gain exposure to the market without the ongoing FX risks or associated hedging costs.

What is left to address?

We still need to make structural and operational reforms in anticipation of the impact that MSCI and subsequent bond index inclusions will have over the next 12 to 24 months. Stock Connect has a daily quota of Rmb13 billion, prompting one fund manager at the RMB Forum in Hong Kong to warn that trading freezes and repatriation risks made it hard for passive funds to enter the market. This is also a problem for daily-dealing Undertakings for Collective Investment in Transferable Securities (UCITS).

Uncertainty over trade settlement has only been partially resolved through the establishment of the Special Segregated Account (SPSA) structure although key UCITS’ regulators point out it does not offer true Delivery Versus Payment (DVP). “In place of real-time DVP, the market creates a 4.5 hour window of potential exposure for investors, which was originally deemed to run counter to the intent and spirit of UCITS V,” said one regional market specialist.

Equally, RQFII and QFII have long been beset by issues around taxation. The handling of withholding tax for QFII and RQFII managers has been an issue which has only increased in importance since the launch of Stock Connect. Stock Connect is currently temporarily exempted from withholding tax. However, QFII and RQFII investors are increasingly unsure about whether to continue accruing for withholding tax, or if they need to prepare for an unwinding of their previous accruals.

Perhaps not surprisingly, given the continuing growth in the number and complexity of access mechanisms, Standard Chartered’s survey highlighted an increasing desire for alignment and simplification in the China Access story. This could take many forms, including merging QFII and RQFII rules entirely, removing legacy mechanisms, or allowing for investments across multiple channels to become fungible. However, there is little evidence so far to suggest this is likely to be a focus in the immediate future.

On the horizon

The reformist agenda is continuing at an incredible pace with the launch of Bond Connect at the beginning of July, which provides international investors with simplified access to CIBM bonds directly from Hong Kong, removing the need to open custody and bank accounts in China. The scheme has begun to attract interest from investors who are new to China or are exploring the market, but do not want to commit to having a direct relationship onshore. Relatedly, the survey found that 27.4% of respondents said they were likely to use Bond Connect in the next 12 to 24 months. All of these reforms help to increase our readiness ahead of the massive asset transitions that we are about to see going into China. With around $16-18 billion of assets expected to enter into Chinese equities through the MSCI inclusion and a further $225 billion likely to flow into domestic bonds following various bond index inclusions, the hardest work is yet to come.

(1) RMB Investors Forum White Paper: Rise of Next Generation China Access – Standard Chartered, May 2016 (online)

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