On June 15 the world’s international equity fund managers were united in one common purpose: anticipation.
They were waiting for US index provider MSCI to reveal whether it would finally include China A-shares in its global emerging market equity benchmark, at the third time of asking.
It was bad news for China bulls. MSCI said it wouldn’t do so, saying the nation’s stock trading and market access still didn't meet international standards.
The day before the MSCI made its momentous decision, another, lower key announcement was made. Insight Investments, a UK asset manager became the first foreign fund manager to register with the People’s Bank of China to invest into the local interbank bond market without any quota and capital repatriation restrictions. Previous QFII and RQFII holders have bought bonds in China, but they were subject to restrictions when doing so.
The two announcements neatly encapsulate the investment dilemma posed by China: huge opportunities, counterbalanced by major risks. Investing into the country isn’t easy, yet it offers potential riches to offshore fund managers willing to chance it.
The reality for international investors is that stock or bond investing into China is risky, whether viewed from an economic or regulatory perspective.
Former China leader Deng Xiaoping used the analogy “cross the river by feeling the stones” to describe China’s gradual economic evolution. He meant the country should only cautiously step into unknown territory.
The country’s regulators have taken this incremental approach to heart. They typically adopt a so-called ‘negative list’ approach, telling foreigners the absolute “don’ts” without clarifying the possible “dos”. The approach appeals to the government. It can shut down behaviour it doesn’t like and add rules as it wishes.
But the risks of this approach were driven home last year. A rapidly inflating stock market bubble burst in June, after which the government embarked on a series of interventions – stock market liquidity injections, short-selling restrictions, trading probes, nods for trading suspensions and an index circuit. These sudden rules changes jarred the MSCI and foreign investors alike.
Beijing’s opaque regulatory approach also applies to the newly opening interbank bond market. Would-be foreign investors are tempted by the available bond yields, but perplexed by a market that has yet to offer clarity on how any investments they make would be taxed onshore and how to hedge their onshore renminbi exposure.
Lack of clarity on such issues makes investing into the market very hard, particularly given the massive currency interventions last year and a weakening renminbi that is likely to weaken the returns of any investments made.
China’s authorities might clarify some of the stock and bond market concerns raised by investors, but they are unlikely to soothe all of them. That offers return-starved international fund managers a dilemma: how much risk is enough, in the pursuit of returns?
Risk versus reward
There are some signs of change. The China Securities Regulatory Commission (CSRC) is said to be improving its communication with foreigners and, under new chief Liu Shiyu, has a more open-minded attitude towards market forces. But the desire of the government, via the CSRC, to manipulate the markets “to protect retail investors” when it deems fit is unlikely to diminish soon.
But this should not make China a black hole for foreign investors. Instead, they could learn more about both the risks and rewards that its markets offer.
Brenda Tse is head of business development at China Alpha Fund Management, which focuses on US-based institutional clients. She thinks many foreign funds don’t really understand China, and better education is needed to reduce concerns about investing there.
That might serve as the strongest merit of MSCI inclusion, however tiny. “Even a small inclusion will bring China on the table for everyone to implement their strategy. They have to decide active or passive, or not investing China,” said a former MSCI executive who preferred not to be identified.
An initial inclusion could translate into 1.1% weighting of MSCI EM benchmark. Cheng Tan-Feng, Greater China head at BNP Paribas Investment Partners, argued that this would make China equities a “structural beta opportunity”, meaning investors would have to actively underweight the country’s equities in order not to invest there. That would encourage more investors to at least learn more about this investment to make that decision.
Bond investors face similar issues. With the yields of trillions of dollars of sovereign debt in Japan and the European Union becoming miniscule amid negative interest rates, the appeal of China’s better-rewarding bond market is likely to force more managers in, even if only in a piecemeal fashion at first. But to enter with some level of confidence, they need to learn more about the issuers for themselves.
When, not if
The inclusion of China stocks and bonds into global investor portfolios is ultimately a matter of ‘when’ not ‘if’. So it behoves foreign funds to begin understanding China better.
Neil Flynn, an analyst at Shanghai-based consultancy Z-Ben Advisors, said foreign asset managers needed to establish an onshore research capability and build build relationships with local asset services providers such as custodians, which are mostly the state-owned banks.
Some institutions are moving along these lines. Twelve US-based university endowments own a combined QFII quota of $1.5 billion. Meanwhile Vanguard, the world’s second largest fund house, started buying A-shares for its emerging-market stock index fund and exchange-traded fund shares last October. Its EM index fund and ETF will ultimately allocate about $3 billion into A-shares, following index provider FTSE’s transition index.
China’s markets offer major investment obstacles, as noted by the MSCI. Yet it also offers potential rewards.
The best investors will be the ones that can minimise their exposure to the former as they seek out the latter.