Accessing China: A Market Inhibited by Regulation

Investor fascination with China continues unabated. China’s economy may be on the downturn but demand for exposure to its potential continues to grow. The biggest obstacle for foreign access –and, for that matter, the growth of its capital markets – remains regulation. Although regulators have relaxed many of the restrictions that limit foreign participation, its capital markets remain a coveted target for the world’s investment community.

A number of prominent regulatory initiatives have been promulgated this year, including a relaxation of foreign investment quotas under the Qualified Foreign Institutional Investor (QFII) program, the establishment and launch of a trial program facilitating short selling of stocks by brokers for their clients, and initiatives seeking to transform the renminbi into a global convertible currency. The list of QFII approved firms has grown to include 220 firms, with 72 firms approved under the program in 2012, illustrating the aggressiveness with which the China Securities Regulatory Commission (CSRC) is broadening access to its markets.

Trading in Chinese domestic securities markets occurs on 7 different securities exchanges. The list of venues includes 2 stock exchanges offering trading in equities and debt instruments and 4 exchanges that trade futures and commodities instruments. Chinese equity markets are dominated by retail investors, a facet that is both desirable and worrisome for Chinese regulators. The emergence of a middle class and the resultant creation of wealth provide a ready source of funds that can support the growing need for capital by China’s emerging private sector. Although derivatives markets are in their relative infancy in China, policy makers have been diligent about laying the foundation for future growth. The government remains relatively conservative in its efforts, however, as futures trading has a somewhat tarnished reputation in China; not surprisingly, regulators wield a heavy hand to control any perceived instances of speculation or abuse of the market.

Investing in China is relatively straightforward for small investors; the challenge is much greater for larger institutional investors seeking to put larger sums of capital to work. The restrictive efforts of China’s regulators have forced investors to be creative in how they approach investing in China.

Unless you are a designated QFII, you have little choice but to use a fragmented patchwork of instruments that provide investors access to Chinese exposure. These instruments include exchange traded funds (ETFs), traditional mutual funds, depositary receipts issued outside of China, through OTC instruments, and through shares in Chinese companies listed on foreign exchanges.

Regulatory obstacles to investing directly in China’s capital markets are numerous, with regulators exhibiting little overt intent to radically open their markets to foreign investors. But direct investment into China is the ultimate endgame for most investors and there continues to be a long line of market participants willing to jump through any and all regulatory hoops to gain access.