China Liberalization of Outbound Portfolio Investment: Precursor to QDII

ii. insurers will be allowed to convert a limited percentage of their renminbi assets into foreign currency, to invest not only in foreign fixed-income products but also in foreign money market instruments, and

iii. mutual funds and securities institutions will be allowed to pool limited amounts from the foreign currency holdings of domestic institutions and residents, to invest in foreign securities, including shares.

The PBOC Announcement is the most significant in a series of measured steps by PRC regulators toward greater capital account liberalization, which is a prerequisite to the government's long-term goal of greater renminbi exchange rate flexibility. The policy set out in the PBOC Announcement paves the way for greater capital outflows from the PRC and will open up opportunities for foreign financial institutions to act as investment managers and custodians, and for domestic financial institutions to play a more important role in overseas capital markets.

Direct goals of the policy appear to include the following:

i. to ease upward pressure on domestic inflation and on the renminbi's exchange rate by opening another channel for capital outflows, thereby absorbing some of the Chinese economy's mounting liquidity;²

ii. to increase the competitiveness of domestic financial institutions by allowing them to gain more experience in overseas capital markets, thereby preparing them for modernization and foreign competition in the PRC's domestic financial sector, and

iii. to broaden the investment options of domestic investors.

Although formal introduction of a QDII programme is expected to occur only at the end of 2006, the market has widely viewed the PBOC Announcement as the programme's effective start-up. QDII would build upon the PRC's experience with the qualified foreign institutional investor (QFII) programme, which in 2002 opened the way for qualified foreign investors to invest in domestic renminbi-denominated financial products. By supplementing the QFII programme with a new QDII programme, the PRC would permit more balanced two-way capital flows while enabling continued monitoring and supervision by its regulators.

Supporting measures for the PBOC Announcement have gradually begun to take shape. Of the three types of financial institutions mentioned, only commercial banks have received formal additional guidance from regulators at the time of writing. On April 18 2006, the Tentative Measures for the Administration of Overseas Financial Management Services Offered by Commercial Banks on Behalf of Customers (商业银行开办代客境外理财业务管理暂行办法) (Bank Measures), were jointly issued by the State Administration of Foreign Exchange (SAFE), the People's Bank of China (PBOC) and the China Banking Regulatory Commission (CBRC). The Bank Measures outline the conditions and procedures for commercial banks to qualify to pool renminbi assets for investment in foreign fixed-income financial products. However, the Bank Measures are vague on specifics such as quotas for overseas investment, and the types of fixed-income financial products that can be invested in. Already, several foreign banks with branches in the PRC have applied to participate in the programme, and public assurances have recently been given that their mainland branches will be subject to the same standards as domestic banks.³ At the end of June 2006, the CBRC announced approvals of two foreign (Hong Kong) banks, Hongkong & Shanghai Banking Corp. and Bank of East Asia, along with four domestic banks: Industrial and Commercial Bank of China, China Construction Bank, Bank of China and Bank of Communications.

Summary of the Bank Measures

The Bank Measures set out the regulatory framework for commercial banks undertaking overseas portfolio investment management on behalf of their domestic customers. That framework includes qualification standards, quota application procedures and detailed 'dual custody' requirements. According to the Bank Measures, the CBRC and SAFE will be responsible for overseeing qualified banks, with the CBRC handling qualification issues and SAFE determining quotas. An important aspect of the Bank Measures is their heavy emphasis on the development of internal controls and risk management systems within commercial banks as a prerequisite for qualification.

Qualification standards

Part Two of the Bank Measures sets out the following conditions for the CBRC's approval of commercial bank qualification:

i. be a designated foreign exchange bank;

ii. have a complete and effective market risk management system;

iii. have strong internal controls;

iv. have the capacity and experience to manage overseas investments;

v. not have been punished by the CBRC for irregular financial management within the year prior to application, and

vi. other prudential conditions the CBRC decides to prescribe.

Documents to be submitted to the CBRC by applicants include the following:

i. an application;

ii. a description of relevant internal controls and risk management system, and

iii. a draft [form of] custody agreement.

Quota application procedures

Part Three of the Bank Measures sets out the quota application procedures. Commercial banks must apply to SAFE to receive a quota for the purchase of foreign exchange to be used in their financial management activities abroad. Banks can issue renminbi-denominated overseas portfolio investment management products only within the amount of the quota. The quota will not apply to investments using foreign currency already held by participating investors. SAFE retains the right to adjust the quota, subject to the PRC's balance of payments situation.

Documents to be submitted to SAFE by commercial banks applying for a foreign exchange quota include the following:

i. an application (including but not limited to basic information of the bank, the proposed quota and the investment plan);

ii. an approval document from the CBRC;

iii. a draft [form of] custody agreement;

iv. a sample standard form of entrustment agreement to be signed with investors, which must contain the parties' rights and duties, benefits, allocation of risk and other relevant content, and

v. other documents that SAFE decides to require.

Within 20 working days after the submission of all the relevant documents, SAFE shall approve or repeal the application.

Dual custody system

Part Four establishes a dual custody system as a risk mitigation measure that is in line with international practice. After obtaining a quota from SAFE, commercial banks are then required to open a custodian account with a separate domestic commercial bank that enjoys a custodian qualification granted by the CBRC ('the domestic custodian') and entrust to it all the assets intended for use in overseas investments. Within five working days after opening the account, the commercial bank must file the executed custody agreement with SAFE. The domestic custodian must then appoint a foreign financial institution to act as an overseas custodian agent.

Responsibilities of the domestic custodian under the Bank Measures are as follows:

i. opening a domestic custody account, overseas foreign currency operation and settlement account, and overseas securities custody account on behalf of the commercial bank;

ii. supervising the investment activities of the commercial bank and reporting illegal investment activities to SAFE in a timely manner;

iii. keeping all records and relevant materials concerning the commercial bank's fund remittances, repatriations, fund conversions, payments and receipts for no less than 15 years;

iv. filing periodic declarations of [its] balance of international payments;

v. assisting SAFE's inspection of the overseas financial operations of the commercial bank, and

vi. other responsibilities that SAFE decides to stipulate.

The domestic custodian must also submit relevant reports pursuant to the following requirements:

i. report to the CBRC and SAFE - within five working days after the opening of each of the domestic custody account, the overseas foreign currency operation and settlement account and the overseas securities custody account;

ii. report to SAFE on remittances and repatriations - within five working days after the remittance of principal, or the repatriation of principal and proceeds;

iii. report to SAFE on the status of the domestic custody account - within five working days after the end of each month;

iv. submit to SAFE an annual report on the overseas operation of the funds of the commercial bank during the previous year - within one month after the end of each accounting year;

v. report to the CBRC and SAFE in a timely manner when illegal or irregular investments occur, and

vi. report on other matters that the CBRC and SAFE decide to prescribe.

Disclosure and transparency

Part Five of the Bank Measures addresses disclosure and transparency requirements, requiring that a commercial bank, disclose completely and in detail its investment plan, products features and relevant risks when selling overseas portfolio investment management products to investors, in order to enable investors to make informed decisions. Additional disclosures to investors are required on matters such as the status and results of investments. Compliance with these disclosure obligations, however, will not prevent a commercial bank from bearing normal civil liability, for example, for its errors or omissions.

In any of the following situations, a qualified commercial bank must make a relevant filing with the CBRC and SAFE within five working days:

i. change of domestic custodian or overseas custodian agent;

ii. material change in the registered capital or shareholding structure of the commercial bank;

iii. involvement in 'litigation' or becoming subject to a material 'penalty' (including a damages judgement), or

iv. other matters that the CBRC and SAFE decide to prescribe.

In any of the following situations, a domestic custodian must file with SAFE within five working days:

i. material change in the registered capital or shareholding structure of the domestic custodian;

ii. involvement in 'litigation' becoming subject to a material 'penalty' (including a damages judgement), and

iii. other events that SAFE decides to prescribe.

Penalties

SAFE will be in charge of imposing administrative penalties on commercial banks and their domestic custodians for violation of the Bank Measures. Under serious circumstances, the CBRC and SAFE may require that a commercial bank change its domestic custodian or may repeal the bank's foreign exchange quota. If the overseas custodian agent refuses to provide relevant information, the CBRC and SAFE may mandate a change of the overseas custodian agent.

Awaited supporting measures

Supporting measures have been slower to appear for insurers and securities institutions.

Since the April 13 2006 date of the PBOC Announcement, insurers' conversion of renminbi assets for investment in foreign fixed-income products and foreign money market instruments has not yet been addressed in supporting measures. However, it is believed that the new policy will first be implemented on a 'pilot' (trial) basis in which selected insurers will be authorized to take the lead. If those pilot trials are satisfactory, an amended version is expected to be issued of the 2004-issued Provisional Administrative Measures for the Overseas Operation of Insurance Foreign Exchange.⁴ These measures, along with the 2005-issued China Insurance Regulatory Commission Notice on Relevant Questions Concerning Investment in Overseas Securities by Insurance Foreign Exchange, already allow insurance companies to invest in overseas financial products using their existing foreign currency holdings, but do not allow them to convert renminbi for this purpose. Most of the foreign currency held by PRC insurance companies originates from their issuance of foreign securities through initial public offerings (IPOs). It appears that to date the only outbound investment approvals under these measures are those that have been issued to Ping An Insurance and China Life Insurance.

Mutual funds and securities institutions have also not yet been addressed in supporting measures. Moreover, given the possible impact on PRC domestic stock markets, of allowing securities institutions to invest greater amounts in overseas markets, such measures are unlikely to be promulgated in the near term. More likely, the new policy direction, as is the case with insurers, will be implemented on a pilot basis, with selected institutions permitted to engage in trial activities. This approach was foreshadowed in March 2006, when China International Capital Corporation (CICC), the PRC's biggest investment bank, won regulatory approval to use existing foreign currency funds of certain clients to buy US treasury bonds and other highly rated fixed-income vehicles on their behalf. CICC has been assigned an initial quota of US$3 million.⁵

The eventual measures, specifying procedures and qualification criteria relevant to outbound investment by mutual funds and securities institutions, are likely to follow the approach of the legislation governing investment by the National Social Security Fund (NSSF) in foreign financial products.⁶ Under the Social Security Fund Provisions, the National Fund Council must engage overseas investment managers to operate and manage the NSSF's overseas investments and must entrust overseas assets custodians to provide related custody services. Qualifications of overseas investment managers must include six years or more of experience in the asset management business and control of assets of US$5 billion or more. Qualifications of custodians must include paid-in capital of US$5 billion or more, or assets under custody of US$500 billion or more, and a credit rating of 'A' or higher for the past three years.

The NSSF can only invest overseas funds that have been obtained from the sale of state-owned shares; its overseas investment cannot exceed 20% of its total assets and may only be in the following types of investments:

i. bank deposits;

ii. foreign government bonds;

iii. PRC government and corporate bonds;

iv. bank bills;

v. overseas stocks;

vi. publicly issued securities market funds, and

vii. swaps, forwards and other financial derivative products traded on financial exchanges.

Risk management and opportunities for all

The PRC's foreign exchange policies have long emphasized stability, risk avoidance and the willingness to learn from the experience of other developing countries. While foreign pressure is probably a factor, a larger reason for the PRC's move towards outbound capital account liberalization is probably its regulators gaining confidence from the results of previous current account liberalization and of the more recent inbound capital account liberalization, along with the perceived growing urgency of providing domestic banks with incentives to develop or acquire risk management capabilities.

As the regulatory programme develops further, both domestic and foreign financial institutions will be in a better position to balance their inbound and outbound activities and to tailor products for Chinese investors. PRC financial institutions will bear less risk from these products, in comparison with previous overseas investments that were made via deposits, which forced domestic banks to bear liability as intermediaries instead of acting as commission-earning service providers.

Risk management will be the key to the ultimate health of domestic banks and up to now has been an area of weakness - even in traditional activities such as domestic lending. The desire to qualify for the emerging QDII programme will be a major new incentive for banks to improve their risk management capabilities.

As they develop or acquire these and related skills, domestic banks and other financial institutions will compete more actively as buyers of a full range of financial products and services - and of financial institutions.

Endnotes

1 See China Law & Practice Vol.20, No.4, pg 37 for a full translation.

2 As of March 2006, China's foreign exchange reserves stood at US$875.1 billion. See the announcement Commercial Banking Industry Undertakes Overseas Wealth Management Services on Behalf of Customers, Expands Investment Pathways for Domestic Individuals - The People's Bank of China, The China Banking Regulatory Commission, State Administration of Foreign Exchange Issue "Interim Administrative Measures for Commercial Banks to Set Up and Operate Overseas Financial Management Operations on Behalf of Clients" jointly issued by SAFE, the CBRC and the PBOC on April 18 2006.

3 The CBRC posted on its website in June a brief statement entitled Concerning Explanation of Questions Related to the "Interim Administrative Measures for Commercial Banks to Set Up and Operate Overseas Financial Management Operations on Behalf of Clients".

4 See Wang, Shuo, et al. "Hu Xiaolian Discusses QDII," Caijing Magazine, May 1 2006, pg 34.

5 The only CICC clients eligible to receive this service are institutions holding foreign exchange deposits of at least US$5 million. See CICC OK'd for pioneer investment, Shanghai Daily, March 29 2006.

6 Tentative Provisions for the Administration of Overseas Investment by the National Social Security Fund (Social Security Fund Provisions), jointly issued by the Ministry of Finance (MOF), the Ministry of Labour and Social Security (MLSS) and the PBOC, on April 30 2006. See China Law & Practice Vol.20, No.5, pg 25 for the full translation and pg 14 for the related analysis.