• In the face of growing pressure of the Mainland China's external imbalances, there is a rising sense of urgency among the authorities to speed up the implementation of the QDII scheme. There are profound implications for the Mainland's financial landscape as well as the economy in the longer term.

A Rising Sense of Urgency

Following the decree issued by the People's Bank of China (PBOC) on 13 April 2006 to establish a Qualified Domestic Institutional Investor (QDII) scheme, it was widely expected that the approval process of granting of the QDII status would not be completed until the end of this year. In the past two months, however, 15 institutions have been promptly approved and granted a foreign exchange conversion limit. The total amount of the limits, at USD10.8 billion so far, is much larger than expected. The approval process is also much quicker than that of the Qualified Foreign Institutional Investor (QFII) scheme, which has been operated for nearly four years, but with only USD7.5 billion investment quotas being allocated to 45 institutions.

There is clearly a sense of urgency among the Mainland authorities to implement the QDII scheme as quickly as possible. Between April and July, the foreign exchange reserves have increased by USD59.5 billion to reach USD954.5 billion. As such, the renminbi is under immense pressure to appreciate while this influx of foreign liquidity has been a cause of rapid domestic monetary expansion, leading to rampant investment growth.

By and large, the QDII scheme is seen as a major step towards capital account liberalization. Regulations from the State Administration of Foreign Exchange (SAFE) specify that Chinese individuals are now allowed to buy USD20,000 of foreign exchange annually, up from USD8,000 before. This implies that this amount would be the maximum of what an individual is permitted to invest abroad via QDIIs initially.

At present, the QDII scheme covers three sectors: qualified commercial banks, qualified securities institutions and qualified insurance companies.

1) Qualified commercial banks are allowed to collect renminbi funds from domestic institutions and individuals, convert them into foreign exchange and invest in overseas fixed income and money market products.

2) Qualified securities institutions are allowed to collect self-owned foreign exchange of domestic institutions and individuals and use the funds for overseas portfolio investment including buying equities. Unlike banks and insurance companies, they may not purchase foreign exchanges from the SAFE to invest abroad.

3) For qualified insurance companies, the implications are not as straightforward. Prior to QDII, they could only use funds received in foreign currencies to invest in offshore fixed-income and money market instruments. By allowing them to convert renminbi funds into foreign exchange, the QDII scheme effectively expands the insurance companies' investment options.

As at 27 September 2006, 14 commercial banks have been granted a QDII license with a foreign exchange conversion limit ranging from USD500 million to USD2 billion. Only one securities institution has been given a license. Its foreign exchange conversion limit is USD500 million. No insurance company has been granted a license at this stage.

QDII Potentials and Market Implications

Private-sector investments in overseas securities via QDII-qualified institutions are expected to rise over time. This will be a significant force in reducing net capital inflows and therefore easing appreciation pressure on the renminbi.

More importantly, by allowing the private sector to hold more foreign assets, the QDII scheme helps relieve the burden on the Mainland authorities to manage the record-breaking level of foreign exchange reserves. Standing close to USD1 trillion, this has brought to the surface an intense debate on the Mainland about why and how the country should manage the funds of such scale. Accumulation of these reserves actually reflects the growing strength of the economy vis-à-vis the rest of the world in the past two decades. This strength should have been translated into an improvement of purchasing power of the private sector vis-à-vis the rest of the world. Instead, this has been materialized through an accumulation of the government's reserves, holding mostly foreign currencies and bonds. The QDII scheme can therefore be seen as one of the ways to allow market forces to determine how to make use of these resources.

By permitting qualified institutions to make offshore investments, the QDII scheme can also provide new investment options for household deposits, totaling RMB16 trillion. When combined with the QFII scheme, which allows foreign capital to invest in the Mainland's A-shares and bonds, the scheme establishes a two-way channel for capital to flow in and out of the Mainland via institutional investors.

As more details are being revealed, the QDII scheme is now developed in two major directions: 1) commercial banks and insurance companies will initially focus on fixed income and money market products; and 2) securities institutions, mostly mutual funds, will invest in equities.

The first QDII products offered by banks are now available. It is reported that, after two months of marketing, four banks have managed to sell only USD200 million worth of QDII products or 3.2% of the foreign exchange conversion limits granted to them. A cautious start from investors should not come as a surprise. It takes time for retail investors to fully understand the overseas markets and the structure of these products.

On the other hand, considering the current external economic environment, the launch of these products could have come at a better time. A steady appreciation of the renminbi is now a generally accepted market expectation. Investment yields from investing offshore are made less attractive by the perceived exchange rate loss. Unless yields are high enough to compensate for possible losses on exchange rate movements, marketing these products to domestic investors will not be easy.

For non-equity-based investment products, the appetite is likely to be small at this stage. The focus is expected to shift gradually to equity products as the market grows and investors become more educated and look for varieties in their investment portfolios. Since qualified securities institutions' products are not confined to fixed income instruments, they are likely to attract those investors who are willing to take more risks. The QDII-qualified mutual funds issued by an asset management company, for example, can be invested in a wider range of financial instruments (bonds, equities, REITS and commodities) in the global markets.

Implications for Domestic Financial Institutions

As at 27 September, no insurance company has been granted a QDII license. How many insurance companies have actually applied for QDII qualification also remains unknown. For them, the benefits of the QDII scheme are quite obvious: an access to high-yielding assets offshore and diversification of risks that are currently concentrated in domestic low-yielding bond markets.

There are trade-offs, however, in terms of additional risks of holding those assets in foreign currency. The financial market on the Mainland is not sophisticated enough to allow insurers to hedge against foreign exchange exposure risks.

On competition levels, domestic QDII institutions have been granted a larger foreign exchange conversion limit up to USD2.5 billion. They have the network and distribution advantage over the foreign banks whose foreign exchange conversion limit does not exceed USD500 million. However, domestic players are apparently weaker in terms of skills and knowledge in internal control, marketing, investing and managing risks in the global markets. To this end, foreign players are better positioned.

Moreover, the QDII scheme grants onshore and offshore registered foreign banks the opportunity to act as custodian. Foreign banks will receive the same treatment as domestic banks when applying for custody services and neither of them will be subject to a higher eligibility threshold. In reality, foreign banks will probably have an advantage in the business of custodianship. Their experience in risk management and maintaining connections on a global basis have made themselves the major providers of QFII custody services. Their scope of business, however, will remain restricted to the regions and the types of business they were granted according to the schedule of financial market liberalisation under the Mainland's commitment to the WTO.

This interesting relationship has therefore fostered co-operation between domestic and foreign players. Alliances along these lines are placing them at a stronger competitive position whilst enhancing protection for the investors against both market and default risks.

Conclusion

The launch of the QDII scheme will not immediately curb the rise of the Mainland's foreign exchange reserves. However, the flows from the reserves to the private sector could be more meaningful in the long term, particularly when the renminbi appreciation expectation begin to wane. Deregulation and competition will take place concurrently in the financial service industry. These processes will be conducive to correcting external imbalances and the long-term growth of the industry.

Hong Kong will definitely benefit from such a change in the long run. It will act as the platform for the QDII funds to invest overseas as many overseas investment companies have presence in Hong Kong, a major regional centre for fund management business. Hong Kong's combined fund management business grew by 25% in 2005 to reach USD581 billion, of which 63% was sourced from non-Hong Kong investors. The increase in market depth and liquidity brought forth by the QDII scheme will in turn attract investors, end-users as well as intermediaries, fostering Hong Kong's position as a major gateway for the growing financial markets on the Mainland.

MAJOR ECONOMIC INDICATORS