Access wall areas

There are many routes to China, but which one offers the institutional investor the most likely path to best execution?
By None

Of the four BRICS countries, China is the most conservative and the most powerful. The World Bank and International Monetary Fund estimated its 2009 GDP, based on purchasing power parity, to be somewhere around US$8-8.7 trillion, making it the third largest economy in the world after the European Union and the United States. It also matched the combined GDPs of the other BRIC countries.

Foreign investors' attraction to the large, wealthy, straight-laced market is clear. But the positive economic picture is offset by a state-controlled, heavily bureaucratic environment with limited interest in outside investment. China is not keen on short-term or indeed any foreign investors and the yuan is not a fully convertible currency making withdrawal of difficult. Restricted rules and infrastructure prevent the latest high frequency trading strategies from being employed.

To trade in Chinese A-shares which are listed on the mainland markets of Shenzhen and Shanghai, an overseas firm needs to become registered under the Qualified Foreign Institutional Investor (QFII) programme. The quotas for QFII firms amount to a total of US$30 billion that can be invested in A-shares, which represents just one day's turnover for the Chinese market.

Getting on the programme is a long and difficult process, although valuable. Aberdeen Asset Management is the latest firm to be awarded QFII status, on 12 August 2010, and is awaiting a quota from the State Administration of Foreign Exchange of up to US$200 million.

The complexity of applying for QFII status can deter. Many fund managers have relied on arrangements with large sell-side firms that have a QFII quota to invest on their behalf. The Chinese government has frowned on this practice, suggesting that firms lending their QFII to others could be considered to have an excess.

Some large buy-side institutions have entered into joint ventures with local firms to get access to the market. Others use shares listed on other markets by mainland firms, or firms under Chinese ownership as access by proxy into the mainland.

For example investment in certain Australian or Taiwanese stocks can provide exposure to China.

Australia has a level of co-dependence with China, on resources particularly, which has led to Chinese-owned firms listing on the Australian exchange providing an indirect point for investment. Some Chinese firms are listed in Taiwan rather than China, presenting an alternate investment path.

Going the other way, Taiwanese firms have successfully made inroads into China. According to research firm Celent, 15 Taiwanese securities firms have moved into the mainland Chinese market, led by Capital Securities in 1997, while 73% of firms listed in Taiwan are investing in China – investment into the Chinese mainland from Taiwan reached $49.5 billion in 2009.

Investment on the Taiwanese and Australian exchanges does not require the same heavyweight qualification procedure as for the QFII.

A slightly less oblique route can be found via Hong Kong. Trading the H-shares of the 120 Chinese firms that are dual-listed on Hong Kong Exchange and Clearing (HKEx) does not require a QFII and therefore affords precious access to outsiders.

But while long-only firms have relatively straightforward access to these 100+ large Chinese firms, the same cannot be said of high-frequency traders.

Although the exchange facilitates algorithmic trading, the HKEx operates a licensing model that allows one order per second per member licence, with a limit of around 150 orders per second, not enough for most high-frequency firms. In addition, stamp duty payments are 10 basis points each way, plus a further 1bp in trading fees, on a trade limiting the potential of HFT strategies.

Nevertheless brokers in Hong Kong claim to be seeing a constant growth in electronic flow, particularly from the US, where night desks are more common than in Europe, and Singapore where many global investment firms have based their Asia trading desks. The Hong Kong market is denominated in Hong Kong dollars, which avoids the yuan's lack of convertibility.

Convertibility is an issue which Hong Kong will continue to exploit as a trading hub and a gateway to the mainland. It has a lead role in the Chinese government's plans to internationalise the yuan. Since April 2009, certain businesses in the mainland have been settling trade in the Chinese currency with their Hong Kong counterparts. That will allow Chinese domestic investors to spread their portfolios' wider, via the special administrative region, and expectation is for investment flows to increase significantly between Hong Kong and the mainland.

For the foreseeable future, access to China will continue to be restricted but perceived as more valuable for it.

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