Goldman Sachs has added its voice to the line-up of international investment banks that view long-term benefits accruing to the Hong Kong stock market from a series of foreign exchange liberalisation measures outlined by China last week. These were widely viewed as a key step towards the long-awaited launch of the qualified domestic institutional investor scheme.

Details of the scheme have yet to be announced and banks and insurance companies will initially only be allowed to convert renminbi for investments into offshore fixed-income instruments, while mutual fund managers will be able to raise foreign exchange funds in the domestic market to buy overseas equities but wonÆt be allowed to convert renminbi into foreign currency for the same purpose.

Domestic financial institutions will also still need to apply for an individual quota to actually start investing offshore. Even so, the forex liberalisation moves suggest the reform wheels are in place for a fully-fledged QDII scheme, analysts say.

In fact, a few domestic asset management firms are believed to have received the green light to invest in foreign equities. This will act as an experiment before the regulators start granting more wide-spread approvals.

According to Goldman SachsÆ China strategist Thomas Deng, the initial money inflow into Hong KongÆs equity markets as a result of this first QDII step is likely to be no more than $6 billion. This would roughly match the money currently invested by Qualified Foreign Institutional Investors into China.

However, the effect will be long-lasting and given ChinaÆs foreign exchange reserves of $870 billion ôthe potential is enormous,ö says Deng.

Goldman expects that the National Social Security Fund could invest up to $2.6 billion through QDII in the initial phase. It also projects the Rmb1.6 trillion ($200 billion) of assets under management at Chinese insurance companies will grow by 10-15% per annum for the next five years and argues that 15%-20% of that growth could be invested in equities with a portion going overseas.

Deutsche Bank last week projected that the fund flows from China to Hong KongÆs equity markets will amount to $2 billion this year and rise to $7 billion in 2008, while Credit Suisse anticipated a first batch of $4 billion to $6 billion of Chinese funds to enter the international financial markets in the next three to four months. For 2006 as a whole, that sum could increase to $10 billion to $12 billion, with about 50% potentially being invested in equities with a bias towards the Hong Kong market, the European investment bank said.

News of the forex reforms sent the Hong Kong market soaring last week as investors pondered the potential impact from such investment amounts. The buying got an extra boost from speculation of a renminbi appreciation in connection with President Hu JintaoÆs visit to the US and talk that the Federal Reserve may be getting ready to halt its rate hike campaign By last Thursday the Hang Seng Index was up 3.1% on the week, while the H share index had gained 6.9%.

Both indexes edged back on Friday and Monday as investors opted to take profits amid rising oil prices.

Like most other analysts, GoldmanÆs Deng believes the Hong Kong stock market û and H shares and red-chips in particular - will be the key targets when it comes to equity investments under the QDII scheme, partly because Chinese investors are already familiar with these companies.

Also, there will be no currency risk if they invest in H shares since their underlying assets are denominated in renminbi and will increase in value alongside a potential appreciation in the Chinese currency, he argues.

Stocks in sectors that are currently not available in ChinaÆs domestic markets are also likely to be key beneficiaries from these investments, Deng says, noting oil, insurance, internet companies, telecoms and independent power producers as the main stocks in this ôscarcity playö category.

Financial services providers, particularly Hong Kong Exchanges and Clearing, will also benefit from the increased cross border flow of money and an expected rise in demand for financial services.

Another type of stocks that is likely to be sought after is the ôvalue playsö which are available in China but cheaper in Hong Kong. These would include electronic equipment producers, airlines, textile manufacturers, and pharmaceutical companies which are all traded at more attractive price multiples than their peers in the domestic market.

Over time, however, such valuation differences are likely to be reduced as the QDDI scheme will help drive further convergence between A shares and H shares.

The key benefit for domestic investors in China, however, will be the greater flexibility that will come with the QDII scheme. ôIt wonÆt necessarily enhance returns, but it will definitely enhance the investment efficiency,ö Deng says.