By Nathan Chow, Group Research, DBS Bank (HK) Limited)
On 6 March, the China Securities Regulatory Commission promulgated new rules for the Renminbi Qualified Foreign Institutional Investor (RQFII) pilot scheme:
- Financial institutions registered in Hong Kong and the Hong Kong units of Chinese banks and insurers will be allowed to join the Chinese brokerages and fund-management firms in the program.
- Participants will now be able to invest in the mainland stock-index futures, initial public offerings, convertible bond sales, and share placements. Previously, they were limited to equities and bonds.
- Restrictions on the composition of investors’ portfolios will be lifted. Prior to changes, investors were required to put at least 80% of their assets into fixed-income securities, with the remainder invested in stocks.
The revised RQFII scheme will allow the introduction of a broader range of RMB-denominated investment products offshore. The RMB use in Hong Kong as well as the circulation of funds between Hong Kong and the mainland will therefore be further enhanced. Meanwhile, the expansion of the program will stabilize any abnormal fluctuations in China’s markets to some degree.
This is important because the mainland markets are currently dominated by local retail investors. They tend to have a shorter-term investment approach that contributes to market volatility. Greater participation of offshore institutional investors thus allows the markets to keep up with the international standards.
That said, there are growing worries over the potential negative impact of the RQFII expansion on offshore RMB liquidity. We think these concerns are overdone. More than offset by the increase in offshore RMB deposits The onshore bond market undoubtedly has its attractions, given its yield curve is about 100bp higher than its offshore counterpart (Chart 1).
The premium comes at a price, however. High concentration of Chinese issuers restrains investors from diversifying their portfolios. Market participants are also exposed to higher credit risks due to the absence of
international rating references and appropriate credit research resources. Such deficiencies may well counterweight the initial onshore yield advantage.
Likewise, lack of transparency and corporate governance surrounding Chinese companies also dampen foreign investors’ appetite in mainland stock markets. Many still remain skeptical of the quality of the listed companies after several fraudulent accounting practices were spotted by western agencies. These largely explain the tepid response of the program. The RQFII scheme, initially approved at the end of 2011, had its quota boosted to RMB270 bn. But only RMB70 bn of that total has so far been utilized. This translates into about RMB5 bn per month on the back of an untapped quota of RMB200 bn. Amid the increasing scrutiny of the Chinese companies and continued improvement in the macro conditions, the demand for RQFII products will likely be stronger going forward. Nonetheless, even if we assume the remaining quota comes in at a quadruple pace of last year’s (RMB20 bn a month), the size is still smaller than the average monthly increase of RMB deposits and CDs combined in 4Q12 (RMB30 bn). In other words, the liquidity shrinkage caused by the RQFII should be more than offset by the increase in offshore liquidity. Various ways to expand the offshore RMB pool If the demand for RQFII products was even stronger than the aforementioned assumptions, the regulators could divert more RMB flow to the offshore market under the capital account. One of the policy considerations would be allowing Hong Kong banks to access the onshore interbank market for funding.
Such a move would increase offshore liquidity and address a structural problem that has not been explicitly discussed in the RMB internationalization roadmap hitherto. Currently, offshore investors are allowed to hold various types of RMB-denominated assets such as deposits, bonds, and A-share ETFs. The increased holdings of RMB assets by offshore investors suggested that China was borrowing from non-residents. This is counter-productive because China, given its enormous foreign reserves in excess of USD3.3 trn, does not need to attract more foreign capital. Hence, a more balanced approach is needed by allowing offshore investors/business entities to raise RMB onshore and hold RMB liabilities. Another plausible option is to allow mainland individuals to participate in the RMB-denominated version of Qualified Domestic Institutional Investor program (RQDII2). Indeed, the People’s Bank of China recently stated that the authorities are actively preparing to launch QDII2. That sent a strong signal to the market that this new “through-train” scheme, which was originally proposed in 2007, should be principally readied and back on track soon.
On the other hand, the authorities can also boost offshore RMB liquidity by encouraging more RMB use in outward direct investment (ODI), the growth of which has been lagging behind the RMB-denominated foreign direct investment (FDI). In 2012, the RMB was used for merely 6% of China’s ODI, compared with 36% for FDI (Chart 2). Relaxing restrictions such as raising thresholds for project amounts subject to approval and simplifying application procedures could support RMB ODI growth. Other policies that are also in the cards include relaxing the RMB daily conversion limits for Hong Kong residents and allowing RMB outward remittance for mainland individuals and corporates (see “CNH: Replenishing offshore RMB liquidity”, 13 Dec 2012). In short, given that there is a plenty of scope for the regulators to expand the offshore RMB pool, the drainage on liquidity caused by the RQFII should be manageable.