One of the pivotal issues in the international political and financial arena is the question of when and how China will permit the appreciation of the renminbi yuan and the free bilateral movement of China’s capital account to ease the imbalances within the international financial system. Additionally, Chinese regulators have recognised the need to broaden the limited channels of overseas investments currently available to domestic Chinese institutions and individuals. Given the rapid growth of the Chinese economy, the burgeoning trade surplus and the high rate of domestic savings, China’s foreign exchange reserves have grown to an estimated $1.3trn (£690bn) in personal savings.
However, it has been administratively difficult for domestic renminbi yuan deposits to be converted into foreign currencies for overseas investments. Often, institutions and individuals have to go through various applications with the relevant regulatory authorities for approval. International financial and political players have lobbied hard for a system in which persons and institutions — qualified domestic institutional investors (QDIIs) — can convert domestic renminbi yuan deposits into foreign currency for over-seas investments.
Despite a number of false starts since 2001 with the initial proposal of the QDII regime by the Hong Kong Government, there appear to be concrete steps taken by the Chinese Government to liberalise the currently rigid regime of capital controls in China.
On 13 August, 2006, China’s first investment fund offering — managed by one of the largest fund management companies in China, Hua An Fund Management and Lehman Brothers — was approved by the China Securities Regulatory Commission and Chinese State Administration for Foreign Exchange, marking a major milestone in the development of the Chinese capital markets.
Implementation of the QDII regime
On 13 April, 2006, the China Banking Regulatory Commission (CBRC), together with the People’s Bank of China (PBC), issued its fifth announcement of 2006 which set the groundwork for a more liberalised foreign exchange control regime.
This was followed by the announcement on 18 April of the Provisional Administrative Rules on the ‘Overseas wealth management business of commercial banks on behalf of their clients’ and the ‘Notice of the CBRC on issues related to commercial banks’ overseas wealth management business on behalf of their clients’, which were the first formalised regulations — albeit limited to banks — to permit domestic foreign exchange to be invested by banks in offshore foreign currency-denominated fixed-income investments under the proposed QDII regime.
The next crucial development was the pilot launch of the QDII investment fund offering by Hua An and Lehman. As alluded to in the PBC announcement number five, the crucial distinction between the Hua An-Lehman transaction and the earlier banking QDII offerings is the wider range of permitted investment powers granted to QDII investment funds to invest in fixed-income and equity instruments. The Hua An-Lehman transaction will invest in a range of fixed-income instruments, equity securities, real estate investment trust securities and commodities.
Key structural features
The transaction uses an existing Lehman Brothers structure — a Cayman entity — to issue the notes, which are designed to give indirect exposure to the underlying investments through the shares of another Caymanincorporated special purpose vehicle company. The notes are purchased, structured and managed by Hua An and used for foreign investment through the QDII regime.
In the absence of formal rules for the QDII investment offerings, the Hua An-Lehman transaction provides insights into the structural requirements for future QDII investment fund offerings.
Given that complex financial instruments such as principal protected notes are relatively new to domestic Chinese investors, it was apparent the Chinese regulators sought to ensure a degree of protection and acclimatisation for such investors. Hence, the principal return of the notes was ensured through constant-proportion portfolio insurance techniques and additional principal protection was provided with a guarantee from a Lehman entity.
Further, there is active participation by a Chinese party in the investment allocation aspect of the transaction, evidenced by the joint exercise of investment powers by Lehman and Hua. Again, this is a possible reflection of the Chinese regulators’ often articulated aim of increasing exposure of Chinese investment professionals and investors to world-class financial practice through cutting-edge investment transactions.
Also, similar to the transaction structure of the banking QDII products, the Hua An-Lehman transaction adopts a dual-custodian structure where a domestic custodian (ICBC) and an international custodian (HSBC) coordinate to provide safeguards to ensure the proper monitoring, execution and investor reporting functions throughout the period of the transaction.
Currently, the total approved investment quota for the QDIIs is approximately $12bn (£6.2bn). Compared with the amount of foreign exchange reserves in China and set against the backdrop of China’s searing growth in foreign trade with its trading partners, this amount is relatively minuscule.
Viewed from this perspective, the potential for future growth and evolution in QDII offerings (particularly in QDII investment fund offerings which could be structured with greater flexibility in underlying investments) is massive. Also, it is expected that the Chinese regulators will build on the Hua-An Lehman framework and implement formalised regulations for future QDII investment fund offerings, to provide further guidance on the reporting obligations with regards to the domestic and international custodians and to liberalise the range of investments the QDII banks products could take part in.
While we await for formalised regulations for an overarching QDII regime, the Provisional Banking QDII rules and the pilot launch of the Hua An-Lehman transaction are major milestones in the liberalisation and modernisation of China’s capital markets.
Angus Duncan is a partner and Yong Kai Wong an associate at Cadwalader Wickersham & Taft.
