China Opens A-Share Market to Foreigners

November 10th 2002 (FriedlNet.com) - On the eve of the 16th Party Congress, the security market watchdog China Securities Regulatory Commission (CSRC) and the People’s Bank of China Thursday announced the launch of a qualified foreign institutional investors (QFII) scheme to come into effect as of December 1st, opening up the hitherto secluded $0.5 trillion A share stock market to the outside world.

To date, foreign investors have only been allowed to buy shares on China’s B share market, which is quite unattractive with a mere market capitalization of about 127 billion Yuan in 2001. This makes up less than 3% of the entire domestic bulk of market cap, which totaled 4.35 trillion Yuan at the end of last year. The rest, made mainly up of A shares, has remained off limits to foreigners wishing to gain access to the vast reservoir of domestically listed firms and largely non-tradable state-owned stocks. The A share market lists more than 1100 companies, compared to the 110 on the B share market. For the mainland authorities, such capital account regulation has proved a useful tool in the past, isolating the growing yet fragile Chinese financial sector from the moods of global financial markets and rampant speculative herding behavior, shielding China from such capital avalanches that shattered the economies of the Paper Tigers during the Asian Financial Crisis in 1997.

Much of the A share market is currently held by the government and not tradable as yet. The plan of opening up to foreign investors entails releasing as much as $240 billion in state-owned assets to open trading in the quest to increase market liquidity and help fulfill the more urgent task of financing pension spending. With the decay of the cradle-to-grave social security scheme of ages past, the country will have to rely more heavily on market mechanisms to ensure the elderly are not abandoned in the future. It is expected that pension obligations alone will reach 3 trillion Yuan by 2025, with about a fifth of the more than one billion Chinese retiring in the next 30 years.

Having understood that the efficient allocation of resources necessitates a mature market fed by healthy doses of liberalization, China is finally jumping over the hurdles of financial modernization. The scheme to be used to give outsiders access to state-held stock resembles the Qualified Foreign Institutional Investor (QFII) category that Taiwan and other countries have successfully adopted in the past. The QFII program will allow certain foreign institutional investors to convert foreign currency into Yuan and invest directly in the Chinese market, albeit only those investors who satisfy certain criteria specified by the authorities. Eligible players are: fund management companies with at least 5 years of experience, as well as insurance and securities companies with at least 30 years of experience, all of which must have had at least $10 billion of assets under management in the past year and have a paid-in capital of at least $1 billion. If implemented correctly, this scheme can block out troublemakers suffering from corto-plazismo and virtually eliminate the potential for speculative attacks, ensuring that only serious investors take part in the country’s fate. Taiwan braved the Asian Financial Crisis thanks to this system, strictly regulating capital in- and outflows and putting a cap on the amount each investor is allowed to invest. The mainland is also expected to keep a close eye on foreign capital investments, the CSRC earlier this year hinting that foreigners will only be able to invest as long as shares are held for more than one year. A provision will likely be added to prohibit funds directly raised on the market to be repatriated, only allowing for dividends and profits from business projects that are carried out with the funds to be transferred abroad. No such provisions were mentioned in the Thursday statement.

However, there may be a downside, as the recent lackluster China Telecom IPO attempts have shown. It seems that foreigners are not as hot on jumping into the Chinese market as previously assumed. Fueling this, the A shares are expensive, trading at a much higher price-earnings ratio than their B share counterparts - this will not be sustainable in the long run when the two markets eventually merge. Adding oil to the fire, recent fraud and scandals, together with the opaque relationship between the government and its enterprise assets are dampening foreign enthusiasm. But we must not forget that the glass is half full, and not half empty - the Chinese economy is growing at a rate that the shrinking developed countries currently can only dream of, and anyone not investing in China’s future now might well regret it later.

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