China has suddenly gone cold on the idea of admitting more foreign investors to its “A” share market

Foreign bankers itching to get a foothold in China’s chaotic, but potentially lucrative, domestic stock market via the year-old Qualified Foreign Institutional Investor (QFII) scheme find themselves in a hall of smoke and mirrors. The QFII scheme is designed to bring some much needed professionalism to the domestic stock market by allowing experienced overseas players limited access to the “A” share markets of Shanghai and Shenzhen, which have a combined capitalisation of around US$500 billion. Until recently, it was ticking along nicely, with a queue of investment banks getting ready approvals for their applications to put money into QFII funds. Not any more.

In October, quotas applied for by QFII licence holders HSBC, Deutsche Bank and JP Morgan Chase were suddenly cut back by as much as half, causing behind-the-scenes dismay as rivals had been allowed to go ahead with their own, often much larger, quotas. There are now nine banks with QFII licences. They were given an original combined investment ceiling of US$875 million.

This time it is not local but international politics that threatens the foreign banks’ ambitions. On one side there is Beijing – stubbornly defending the yuan’s dollar peg (it is fixed at 8.28 to the US dollar). On the other is Washington which, in the face of a mounting trade imbalance with China, is insisting Beijing revalues.

The irresistible force seemed to have met an immovable object in China’s own back yard at the Bangkok gathering of the Asia Pacific Economic Cooperation in mid-October. The Americans could not get the yuan issue on the official agenda, and Bush had to be content with making overtures in bilateral talks. The Chinese gave him something to take home, but not much. President Hu Jintao indicated that Beijing would study the gradual removal of capital controls on the yuan. But that has been official party doctrine since 1994. Now there is a growing belief that the QFII scheme is being reined in because of suspicion that foreigners are really using it to put hot money into the yuan, expecting to reap profits out of a revaluation. This has been denied in Beijing. But it is worth noting that the QFII licences are handled by the State Administration of Foreign Exchange (SAFE), whose principal role is to protect the currency.

The future of the QFII will now become clearer as other banks line up for their quotas. CSFB was awaiting a decision in mid-October, even as UBS, the first bank to be given a QFII licence, announced that it had fully invested its original $300 million quota on behalf of clients, and would be looking for more. The head of China equities for UBS, Nicole Yuen, did go on the record to deny that what she called a “gradual inflow” had been prompted by currency considerations.

Société Générale has also joined the quota queue, along with ING and Citigroup. Banks are looking to fund managers as long term customers for “A’” shares. HSBC Asset Management has launched an “A” share fund. Martin Currie manages a QFII fund, distributed through UBS, while Franklin Templeton is taking the direct route by applying for its own QFII licence. Because of the scheme’s restrictions on remittances, however, it has no plans to launch a fund.

Templeton’s Mark Mobius has no doubt that currency will be one of the major considerations in processing applications. “We must remember that the driving force is the foreign exchange situation. The whole idea of having a QFII regime is to control foreign exchange flows so any approvals, reductions or increases in quotas, etc. will be driven by those considerations. That is changing continuously and is difficult to predict,” he says.

All of which contrasts sharply with events across the Straits of Formosa. Taiwan’s Securities and Futures Commission (SFC) has just eased the path of foreign investors by removing the local QFII scheme and simplified the registration process.

For more information about the Chinese markets see Focus on Finance April, China – a risky opportunity click here