In Gavin Menzies' controversial book, 1421, which relates in great detail how it was the Chinese that discovered America, a scene describes how Emperor Zhu Di awarded the command of five treasure fleets to loyal Admiral Zheng He. His task was to promote “Chinese trade and influence in Asia, India, Africa and the Middle East … he was to lead one of the largest armadas the world had ever seen”
Nearly 600 years later, China is once more on the verge of an epic voyage of discovery but of a different sort. Whereas the ships carried “crates of blue and white porcelain, rolls of silk, bundles of cotton cloth and bamboo cases of jade”, this time, it would be electronically shipping millions of dollars of investments into financial markets both near and far. With foreign exchange reserves expected to have crossed US$1.7 trillion at the end of April 2008, the largest in the world, the Chinese authorities are under considerable pressure to deploy part of these formidable reserves offshore.
But as China marks the second anniversary of its scheme to invest offshore, the Qualified Domestic Institutional Investor (QDII) programme, there seems to be little reason to cheer. In late March 2008, China Minsheng Bank became the first institution to close down a QDII fund as its value fell below 50%. While an array of QDII products caused a market frenzy in 2007, so far this year they have failed to gain traction.
Despite this lacklustre performance and global market turmoil caused by the American subprime mortgage meltdown, Beijing is determined to allow QDIIs continued access to overseas financial markets, hoping that the country’s excess liquidity can be channelled abroad, and that the significant capital outflows will spur demand for foreign currencies, thus reducing the pressure on the appreciation of the renminbi.
But it is more than that. Viewed from a broader perspective, says Stuart Leckie, chairman of Stirling Finance, a Hong Kong based consulting firm on pension and funds, QDII also marks “the start of China’s opening of its capital markets”. And given the size of its foreign exchange reserves, China and its QDII scheme may well define the flow of global capital in the decades to come.
Market gloom belies Beijing fervour
There seems to be a mismatch between Beijing’s optimism about QDII products and prevailing market sentiment, which seems to have turned sour: ICBC Credit Suisse Asset Management – which had announced in December 2007 that it was to raise 22 billion renminbi (US$2.87 billion) with its China Opportunity Global Stock Fund, the first QDII fund of 2008 – eventually managed to raise a mere 3.15 billion renminbi, only a tenth of the amount collected by four similar products last year.
Disgruntled investors gripe about the zero or even negative return on some of the QDII products. One that has sparked the greatest outcry is “Licaitong no 1”, launched by Bank of East Asia (BEA) last September, whose net value had dropped 63% as of February 14 2008.
Lau Tsz-lung, deputy head of international investments at China Universal Asset Management (CUAM), notes that Chinese domestic investors tend to rate the performance of mutual funds in absolute terms whereas investors in mature markets are more accustomed to measure the performance relative to a benchmark.
Lau, a Hong Kong citizen with an MBA from Cambridge University, used to manage balanced funds including five Mandatory Provident Funds (MPFs) at Citigroup Asset Management in Hong Kong, having a total of US$400 million assets under management. The balanced MPFs under his management constantly figured either in the first or second quintile in the ranking of Lipper Analytical Services Inc. Lau moved to Shanghai in late 2005 as the chief representative for HSBC Investments and in 2007 joined CUAM overseeing QDII products.
CUAM is a 100% Chinese-owned asset management company. As of late 2007, it managed total assets of 35.4 billion renminbi. Its largest shareholder, Shanghai-based Orient Securities Company, owns a 47% stake. CUAM’s second-largest shareholders are China Eastern Group and Wenhui-Xinmin United Press Group (WXUP), each holding a 26.5% stake. China Eastern Group is one of three state-owned aviation enterprises in China, while WXUP is one of the largest publishers in China, with a total of 29 publications, including 17 newspapers.
CUAM currently has 26 members in its investment team. Their average working experience in the securities market is around eight years. 19 fund managers hold a post-graduate degree in various disciplines and two have overseas working experience.
According to a February 2008 report from the Southwestern University of Finance and Economics (SWUFE), in Chengdu, China, 32 commercial banks in the country issued 218 wealth management products, of which the number of QDII products fell to 10 from a record 64 in January. Apart from the turmoil in global financial markets, another reason for the slump, according to the report, is that 59 out of 64 QDII products launched in January are open-ended, and this reduced the market appetite for similar products. On the other hand, the report points out that the issuance of short-term guaranteed fixed income products increased while the number of IPO, equity and trust products remained steady.
Undaunted bulls
Amid such worries that the QDII market is contracting, and in spite of the disappointing performance of some QDII products this year, many institutions remain bullish and are set to launch either new QDII products or their first-ever QDII fund.
Hua An Asset Management aims to launch a QDII fund this year, two years after it introduced its first-ever product to the market in mid-2006 as a regulatory testing ground. Portfolio manager Eric Su does not seem to worry about the lacklustre appetite of retail investors and the disparaging news headlines. The exuberant market response for the four funds last year was ‘abnormal’, Su argues, while the one for ICBC Credit Suisse was more typical. Su likes to point out that Hua An, which is currently applying for additional QDII quota, won’t set a target for the amount of funds to be raised, confirming in effect that fund managers consider a product’s performance rather than the market subscription as the yardstick of success.
Echoing Su, Zhang Xiaogang, a fund manager at E Fund Management, says it does not matter whether his company raises 4 billion renminbi or 40 billion renminbi, as long as it can show the market the product’s performance. “The valuation is attractive now, and China is expected to sustain good economic growth,” he believes. E Fund has submitted its QDII fund application for regulatory approval. Once this is obtained, Zhang says, the company will launch the fund regardless of the prevailing market condition.
QDII funds launched by fund houses are generally perceived as higher risk because they have no restriction on the amount they invest in equities. Zhang says the reason why E Fund has designed its upcoming first QDII fund as an equity fund is to accommodate the market appetite for such risk.
Similarly BEA, which launched the ill-fated Li Chai Tong no 1, remains keen on QDII products and is planning to introduce a new QDII product within two months, albeit with a market view and strategy different from Zhang. Andrew Kung, BEA’s deputy general manager of personal financial services and wealth management, says the focus this year will be more on open-ended guaranteed products like Asian bonds or emerging market bond funds. Unlike some banks that link structured products with delta-one notes, BEA prefers open-ended funds because no trading fee is required and investors are not forced to liquidate at an unfavourable time. Kung adds that the continued weakness of the US dollar has made US-denominated structured products all but impossible.
Traditionally, QDIIs invest mostly in H-shares because the Hong Kong market is more familiar to Chinese domestic investors. Zhang of E Fund Management, however, suggests that market familiarity is not a concern to them. “We invest in Chinese companies because they are recognized as having good growth potential. If they do not grow, it is meaningless whether they are Chinese companies or not. In a global economy, no market is considered too far away. We are not familiar with the Indian market either, but we invest in it because it is experiencing strong growth and great domestic demand.”
BEA’s Kung believes H shares are still more popular and widely accepted in the Chinese market “because it is what the average Chinese investor understands better. For example, Apple is a good share, but investors do not know much about it. However, when you tell them about Lenovo, they know. There are a lot of good buys in other markets, but we have to educate investors.”
New players too are eager to get their slice of the pie. HSBC Jintrust Fund Management, a joint venture of HSBC and Shanxi Trust & Investment Corporation Limited (Jintrust), is hoping to obtain regulatory approval to launch a QDII fund this year. Jintrust, set up in May 2005, will have been in the securities investment fund management business for two years this coming May, thus meeting the first requirement for a fund management company (FMC) to gain QDII status. However with current net assets of only around 100 million renminbi, it fails the second requirement: having net assets of at least 200 million renminbi. Also, there is still a third requirement: having assets under its management of not less than 20 billion renminbi or the equivalent in foreign exchange assets as at the end of the most recent quarter.
Steve Lee Suen-chun, CEO of HSBC Jintrust Fund Management, says the company will apply for its QDII quota once all requirements are fulfilled. He adds that launching QDII funds is a long-term strategy of Jintrust and the company has been preparing for the new business by communicating to retail investors, so it will go ahead regardless of the prevailing market conditions.
Lee may take comfort from the fact that the Chinese Securities Regulatory Commission (CSRC) since the beginning of 2008 has become more efficient in issuing quotas. And JPMorgan has estimated that the size of QDII fund quotas may jump more than three-fold to US$90 billion this year.
Rough road ahead
Yet, the road ahead for QDII products is strewn with obstacles of various sorts: Due to the constraints on QDII products, even some simple foreign exchange products fail to obtain regulatory approval, according to BEA’s Kung. “If a QDII product wanted to invest solely in Hutchison bond, that would be impossible. If we wanted to simply link the product to a few equity notes, it would not be allowed because the notes could not possibly take up more than 50% of the portfolio. In the end, we can only do pure fund products.”
Another obstacle presented by the present approval system is that while it may take up to a few months for a product to obtain approval, QDII funds, once approved, must be launched into the market within one month. Needless to say, by the time a fund reaches the market, it may no longer be the most suitable product given the ever-changing circumstances.
Then there is the perception that many QDII products are vague in disclosing such information as basic assets, structure and expiry date, according to a report issued on March 1 2008 by the Chinese Academy of Social Sciences. It “blacklists” six banks for their lack of disclosure on wealth management products. Surprisingly, four of the blacklisted banks are foreign: HSBC, Citibank, Hang Seng Bank and BEA. The other two are the China Everbright Bank and the China Merchants Bank. Despite BEA being one of the banks on the list, Kung does not agree that institutions have failed to make adequate disclosures. He faults some investors for going as far as to demand details on how to calculate an option. Kung reckons such attitude boils down to a distrust of the system, whereby investors tend to blame the system whenever the investment outcome is not as positive as they had hoped for.
On the supply side, two factors combine to cool the offering enthusiasm of foreign bank subsidiaries that have a QDII status. First, the renminbi – which has gained 4.3% against the dollar so far this year – is forecast to rise 8% against the greenback in 2008, making offshore foreign currency investments more expensive. Second, foreign bank subsidiaries must abide by a rule requiring them to keep loans in the local currency below 75% of deposits within two years after set-up. As foreign bank QDIIs invest offshore, the invested capital is taken off the balance sheet and is no longer counted as an asset of the bank. This, in effect, slows the pace at which the regulatory target of a loan-deposit-ratio below 75% can be reached.
At the micro-level, the lack of an international vision affects the investment judgment of staff for QDIIs. Given the extraordinary growth in the Chinese economy in the last decade, few in China have felt a need to learn about foreign investment products. Now, as the dollar depreciates and some foreign assets become even cheaper, they find it difficult to put the principle of diversification into practice.
According to law, a QDII is expected to work with an approved overseas investment consultant when launching products so that QDIIs can learn from their foreign partners and build up expertise. To this purpose, regular internal training sessions and seminars are organized for employees. Two years have passed since QDII was introduced, yet China still has a long way to go as far as developing a sophisticated market is concerned.
But Lee of HSBC Jintrust Fund Management is undaunted by such challenges and believes that even though investors do not fully understand QDII products right now, they are on the cusp of taking off, and will be riding on the Asia wealth effect in a few years’ time. “The situation is similar to the time when China first introduced the domestic open-ended fund: The first fund was over-subscribed on its launch day, but it was only in 2006 that market really took off.”
