China is Opening the Door to Investment in US Stocks and Funds

The China Banking Regulatory Commission (“CBRC”) is expected to soon enter into a memorandum of understanding with the U.S. Securities and Exchange Commission (“SEC”) that will allow Chinese commercial banks that offer wealth management services to invest in equity securities (including investment funds) in the United States under China’s Qualified Do- mestic Institutional Investor (“QDII”) program. If finalized, the move would further expand the CBRC’s recent liberalization of the QDII pro- gram through entry into comparable memo- randa of understanding with the UK’s Financial Services Authority in December 2007 and the Monetary Authority of Singapore in January 2008. The United Kingdom and Singapore are only the second and third markets, respectively, to sign a memorandum of understanding with the CBRC. Prior to December 2007, Hong Kong was the sole market which was covered by the QDII program. The CBRC also has announced that it intends to enter into memoranda of un- derstanding with Germany and Japan to widen the QDII program further.

While the immediate impact of entry into a memorandum of understanding with the SEC likely will be modest, the move provides U.S. funds and managers with an opportunity to ac- cess Chinese investors without having to utilize local intermediaries or partners, or otherwise offer services and investment products into the Chinese markets. In addition, it offers the po- tential for significantly increased access to Chi- nese investors and their assets in the event of a future expansion of the QDII program as China liberalizes foreign exchange controls, gains greater experience with overseas investment, and seeks greater diversification and returns to meet significant long-term retirement funding obligations.

The QDII Program

The QDII program was formally launched by China in 2006 as a means of easing upward pressure on asset prices and giving Chinese investors and intermediaries greater experience with, and access to, overseas investment. Under the program, selected Chinese commercial banks, investment managers, brokers and in- surance companies that have been approved as QDIIs may invest client assets in overseas mar- kets notwithstanding China’s otherwise strin- gent foreign exchange regulations.

When first authorised, the QDII program only allowed QDIIs to invest overseas in fixed income products (including bonds and notes). The ini- tial reception was tepid, as Chinese investors preferred to keep their money at home in China with its booming stock market and the steady appreciation of the yuan against the U.S. dollar. In May 2007, the CBRC issued a notice that significantly expanded the permitted scope of investment by commercial banks under the QDII program to allow Chinese commercial banks to invest in equities and funds authorised by a supervisory authority with whom the CBRC has a memorandum of understanding. It is worthy of note that the May 2007 notice does not apply to other types of QDIIs. As of a recent date, 21 commercial banks had been authorised to in- vest approximately US$15.1 billion under the QDII program.

Permitted Investments for QDIIs

Chinese commercial banks raise assets for the QDII program by packaging investment prod- ucts to which investors subscribe and over which the banks have discretionary management au- thority. If a bank invests QDII assets in overseas equity securities, the investments must satisfy the fol- lowing requirements:

• the equities must be listed on an overseas stock exchange; 
• no more than 50% of the total net assets may be invested in equities, and any investment in a single issue should not exceed 5% of total net assets; 
• the minimum amount which any client of the relevant bank can invest is 300,000 yuan (approximately US$42,000) - a very large sum for the majority of Chinese, as the per capita GDP of China approximates US$2,000;1 
• each client must have experience with investing in equities, and banks must formulate specific evaluation procedures to confirm suitability; 
• any offshore investment managers retained to assist a Chinese bank with investing its clients’ assets must be registered or approved by a regulatory authority which has entered into a memorandum of understanding with the CBRC (“Relevant Regulatory Authority”); and 
• the exchanges on which the equities are listed should be regulated by a Relevant Regulatory Authority. 

In addition to direct investment in stocks, the May 2007 notice also contemplates that QDII assets may be invested in overseas funds, and specifically in “public” funds that have been approved, registered or ratified by a Relevant Regulatory Authority. At least two significant interpretive issues exist with respect to the ability to invest QDII assets in funds. First, the “public” qualification is understood to prohibit in- vestment of QDII assets in hedge funds. However, it is worthy of note that as of a recent date, the Hong Kong Securities and Futures Commission (“SFC”) (the origi- nal Relevant Regulatory Authority) has authorised 14 hedge funds for retail sale in Hong Kong. The status of these hedge funds for QDII investment is unclear. Second, while the notice’s language is ambiguous, there does not appear to be a percentile limitation on investment in equity funds or investment in any single equity fund, as there is with respect to direct invest- ment in equities.2 Anecdotal evidence suggests that a QDII bank is not limited to investing only 50% of QDII assets in equity funds.

QDII banks also may invest client assets in investment grade fixed income securities, structured products issued by financial institutions that are rated A or above by an internationally recognised rating agency,3 and derivative instruments (but only for hedging purposes).

Opportunities and Obstacles

The expansion of the QDII program represents an en- couraging sign that U.S., UK and other asset manag- ers and investment companies may obtain increased access to Chinese investors. However, tapping into this market via the QDII program will likely be a long- term project. Despite the recent liberalization of the QDII program, there has not been any sudden rush by the Chinese to invest overseas, particularly as major stock markets around the world have experienced in- creased volatility. Nearly all QDII products which have been made available to investors to date have been undersubscribed. As the Wall Street Journal Asia com- mented on January 30, 2008, “quite simply, investors in China don’t think the rest of the world looks very attractive right now”.

Furthermore, there currently are only 21 Chinese commercial banks formally licensed to develop QDII wealth management products. In light of the increas- ing number of jurisdictions whose regulatory authori- ties are negotiating memoranda of understanding with the CBRC, the relatively small number of Chinese banks authorised under the QDII program, and the relatively small amount of assets authorised for over- seas investment, competition for access to QDII assets likely will be fierce. Asset managers will need to work closely with Chinese banks and, where possible, take advantage of pre-existing relationships to pro- mote their funds and services.

Finally, it is unclear what effect, in the short term at least, the U.S. subprime crisis will have on Chinese investment in the United States when the QDII pro- gram finally opens to U.S. markets.

Despite the obstacles noted above, it is widely believed that the expansion of the QDII program will have a significant long-term impact on the approved foreign markets, as well as on China. Expansion of the markets in which QDII assets may be invested will give Chinese investors increased access to a more diversified array of investments and investment advisers, and likely will encourage further liberalization of China’s foreign exchange controls and Practice group contacts d restrictions on foreign investment. This, in turn, may help relieve inflationary pressures and the potential for asset or stock market “bubbles” in China. Eventually, expansion of the QDII program should help non-Chinese asset managers gain greater access to the estimated US$2.4 trillion of savings in China as these assets are put to use in addressing the retirement fund needs of an aging Chinese populace.

This update was authored by Keith Robinson (+1 852 3518 4705; keith.robinson@dechert.com), Basil Hwang (+1 852 3518 4788; basil.hwang@dechert.com), and James Stonehill (+1 852 3518 4708; james.stonehill@dechert.com).

Footnotes

_{1) See World Economic Outlook Database, October 2007 Edition, International Monetary Fund,  (based on 2006 figures). Some indus- try observers have speculated that this requirement will be relaxed, or outright abolished, in the future. 
2) Investments in a U.S. registered fund by a QDII investment product may raise issues under the percentage restrictions of Section 12(d)(1) of the Investment Company Act of 1940. 
3) The rating requirement applies to the issuer, not the issue, which limits investment in structured products issued through special purpose vehicles.}

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