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You made the point that it would need a return as large as a 12-15% appreciation expectation of RMB plus a deposit interest to make sense to put the money elsewhere. But don't forget that the real rate in China is negative. And more importantly, can local Chinese found any better investment solutions than the QDII? A deposit in the bank account losing its purchasing power day by day? Or put the money into the equity/property market which has every sign of a bubble? Just look at the frenzy debut of the gold futures last week, a premium of over 100 dollar per ounce above global price. Though the premium is short-lived, one thing clear is that the trapped liquidity has nowhere to go, but pushing up the asset price in new territories. The valuation of HK market, is extremely attractive compared with the domestic A shares. I think it makes perfect sense to diversify the assets abroad through QDII products. Even though we use the word abroad, most QDII products invest in HK only, or Asia Pacific region. It is highly likely they will outperform domestic A shares by a large margin when the US recession panic is fully discounted in the share prices in these regions.

I aggree with Yuan Zi. My guess is that the real return rate in China would not be that high, if you take inflation into consideration. Of course this does not matter to the foreign speculators. However it matters for Chinese investors. Now we are probably near the top of the asset bubble and the developed markets are clsoe to the bottom of the bubble. I expect that we will see a booming QDIIs in 2008.

I am back to my former comment. The CNY will at one point start to fall, surprising everyone.

The Valuation gap between HK-A share convergence does not mean HK must rise, it could outperform A share even both market posted Negative return

Yuan Zi and Fatbrick, I think you are confusing the meaning of real rates in this context. When comparing investments you must always compare the nominal rates of return, not the real. The fact that real rates in China are negative is irrelevant when comparing Chinese and foreign rates of return. If you invest in a foreign asset that returns 10% in dollars (a very high expected return, especially when compared to the low-risk of bank deposits) and the RMB appreciates by 9%, your return in RMB is less than 1%. If you compare that with a Chinese bank deposit, you are worse off in spite of having taken a lot more risk. In that case the real rate of return in RMB terms for a foreign investment is even more negative than a Chinese bank deposit. Basically if the nominal rate in RMB terms is lower abroad than at home, it is a worse investment -- and this does not even consider the return on a risk-adjusted basis.

Isaac of course is absolutely correct. The fact that H-shares are cheaper that A-shares only means that over the long term they will outperform, but the long term could be years. In 2008, there is absolutely no guarantee that H-shares will rise by the 12-15% necessary to match the return on RMB bank deposits, and any investment in H-shares should outperform RMB bank deposits by at least several percent to account for the risk -- after all, H-shares could actually decline in value, as they have done recently, while bank deposits have no risk of declining unless Chinese banks default on their depositors.

A2, if the RMB depreciates in 2008 it will certainly surprise everyone, especially me. It would also almost certainly start a trade war. I am not sure why the Chinese financial authorities would want to demolish what is left of their monetary policy, push inflation up, and start trade wars, but maybe you have a better sense of their goals than I do. At any rate if you are confident of your prediction I suggest you short RMB NDFs, where you can make money if the RMB appreciates by less than 8-9% and where you can make a fortune if it declines.

The real proof is in the pudding. So far QDII investments have performed worse than bank deposits. If Chinese investors don't mind and pour more money into QDII, it means they are willing to take the expected nominal losses in exchange for diversification. My guess is that QDII investing will be unpopular this year. We'll see.

macro trade in China: besides high risk shorting equity/property

it is good to go long Rmb NDF in 1-3 month horizon with market pricing for only 0.1-2% appreciation while there is fair chance of 2-5%

Short 5-10 year interest rates is not bad either.

Point No.1: Compare apple with apple, the real return expected from moving your US dollar assets abroad to deposits in China, equals to an appreication in RMB plus deposit rate minus inflation. And I assume the investors would care more about real rate of return rather than nominal.
Point No.2: China inflation is at decade high of 6.9% while in the US the recession could lead the economy to the deflationary environment.
Point No.3: A-shares and H-shares could converge on either up or down side, and I dont even believe they are likely to converge at all any time soon. (look at the HSAH Premium Index). The point I wished to make however is that H shares valuation is much attractive compared with domestic A shares. And this is extremely true after HSCEI touched the 200 day MA yesterday.
And finally, whether a domestic investor put his money in the bank account, losing in real terms, or investing in equity market entirely depends on his risk preference. It would be sad if your conclusion is that the best investment solusion available for local Chinese is bank saving.
And I agree with you, QDII might be unpopular in 08, giving its poor performance in the past several months. Nevertheless, it is a sound investment as well as diversification tool for local investors.

michael -- great post. the fall in chinese household's dollar denominated bank deposits is another data point supporting your analysis. i am continually amazed by the number of policy makers (especially in dc) who think the reason why China has such large reserve growth is b/c China doesn't allow capital outflows (as opposed to at the current exchange rate, Chinese citizens prefer RMB to dollars).

yuan zi -- a lower nominal return on $ investments (in rmb terms) than on rmb investment (in rmb return) translates to an even lower real rate of return on the $ investment (in rmb terms).

isaac -- when i look at a bloomberg screen, the 3m forward seems to be pricing in an annualized rate of appreciation of over 9% -- or a bit more than than the appreciation implied by the 12m forward.

Well, do we really have an arbitrage situation in terms of the RMB? Borrow USD in the US, invest them in China. Make money from 1) the interest differential and 2) the RMB-appreciation. Or is there any risk? Ok it is not easy I guess practically to do that trade, but exporting and importing companies have large flows of capital, so I would guess that for instance American importers could be hoarding RMBs in their Chinese subsidiaries. I would say, we do not have an arbitrage trade, but rather, because people believe so, we have big risks.

As I understand it, people are getting unwilling to hold RMB on savings accounts. They move them to current accounts. They move current accounts to cash. They move cash to goods. The velocity of money increases.

Banking becomes less profitable by high reserve requirements. Thus, I guess, companies turn to stock issues, circumventing the banking system, financing themselves directly from the public, who wants to invest/use their cash.

The result of theses spirals should be an absorption of more import goods, and a domestic competition for export goods. In other words, a rapidly falling trade surplus. And, I guess, nervousness among those who are possibly holding RMB instead of USD for arbitrage purposes.

The $90 billion number involves deals that are in the pipeline. There's already been $25 billion which is moved overseas so I'd hardly call QDII a bust. Yes we are no longer in a situation in which the quota gets filled on the first day, but the fact that people aren't looking at investments like lottery tickets is a good thing.

Yes if you if you are short term investor, you are probably going to play currencies. However, if you are trying to be a long term investor and put away money that you don't want to touch for another several decades, you are better off putting it in some mutual fund that invests somewhere other than Shanghai, because your changes of timing everything right aren't that great.

On other other hand H-shares are trading at huge discounts with A-shares so if you are saving money for retirement, you are better off putting your money in H-shares because a one time jump of 10%-15% is going to be swamped by the return on stocks over 30 years.

Also if you put your money in HK red chips then any currency change is also going to be reflected in the stock price, even though it might get removed by the noise of the market.

On the other hand if inflation is running faster in China than in the United States that means that the value of the RMB will fall relevant to the USD, which means that 15% sure-thing appreciation you are counting on, might not happen or might be 5% or 10%.

In other words, be holding RMB, you are betting that the adjustment is going to manifest itself in the RMB appreciating in value with respect to the USD rather than in inflation. It's a bet, and I think its a bad bet.

Curious about this Credit Suisse QDII report: Have tried to get a copy from Credit Suisse; they claim no such report exists. Anyone here have it? Are you sure Michael that it was Credit Suisse? If anyone has a copy, I'd sure like to look it over -- I have an e-mail account if someone has an e-copy: cyclist4096@hotmail.com. Thanks much.

The $90bn figure comes from research reports by Jing Ulrich of JPMorgan, and and it breaks down to $45bn from asset managers, $25bn from insurance companies, $15bn from banks, and $5bn from security houses. Not all of this is retail investors. Also the reference to Credit Suisse may have something to do with the fact that they requested $3bn in QDII rather than $4 bn that most houses have gotten. I should note that you should take everything you read in an IB research report with a grain of salt as well as anything you read by an anonymous poster on the internet because you really don't know what conflicts of interest people have.

The good thing about QDII is that it provides a channel for investors who are not speculators. Yes, a lot of the excitement about QDII has been due to people who want to make a quick buck, but the fact that things have cooled down is a good thing. The fact that people know that they can lose 10% in one quarter keeps out the speculators and puts in the investors, since if you care about fundamental value, then a 10% drop makes the stock more attractive, not less attractive. If the Shanghai stock market continues in the current direction for another year, then Shanghai stock starts to be fairly valued.

Looking at the numbers, I think that much of the QDII interest is not company from retail investors. Someone who wants to gamble 1000 RMB might play currencies, but this is not the type of thing that an insurance company should be doing or for that matter someone that wants to save for their kids college fund or their retirement fund.

Also about why you'd invest in QDII if there was a 15% sure thing in a bank deposit.

1) It's not a sure thing. Worst case scenario is that the PBC doesn't revalue and the Fed tightens rates, you get inflation spike, in which case a savings account in China turns out to be a bad thing. There are other scenarios under which you could lose your bet. You could win the bet, but it's not a sure thing.

2) If a money manager was 100% sure that RMB would appreciate by 15% and was right, then there are ways of making lots more than 15% in a stock transaction. You'd look for companies that are long RMB and short dollars and invest in those companies. The problem is that if you are wrong, you end up losing the bet, but that's the market for you. Things get even better if you think that the problem is not a strong RMB but a weak dollar, because you can invest in companies that are long euro/yen/pounds etc. and short dollars.

For this you need QDII, since most of the companies that you'd be interested in investing in aren't listed in Shanghai, and also you need balance sheets that you can trust and those are a bit more difficult to find in Shanghai than in other places.

3) I've heard complaints that the Shanghai stock market is a political market unlike Western markets in which governments don't intervene in markets. In hindsight this is funny after today's events in which you have people in Washington DC talking about how to basically prop up the markets after a 300 point Dow drop,

Twofish, thanks for the research and the numbers. On your first comment, the PBoC has already made it very clear that they expect to run real interest rates back into positive territory. If high levels of inflation persist in China you would still get the full benefit of the real appreciation via a higher deposit rate. Of course you are right that one can create plausible scenarios in which it is better to take money out of China than bring it in, but my point is that RMB appreciation creates a serious headwind that is far more likely to encourage inflows and discourage outflows. Your alternative investments to take advantage of RMB appreciation are not terrible useful except in theory. You say “If a money manager was 100% sure that RMB would appreciate by 15% and was right, then there are ways of making lots more than 15% in a stock transaction. You'd look for companies that are long RMB and short dollars and invest in those companies.” But which companies? Basically the company would need some weird (and highly levered) capital structure in which, for example, it would have to be short dollars equal to 50% of its assets with no RMB debt. These companies may exist in theory, but with the government making it very difficult for companies to borrow abroad for local investment, I am not sure they exist in practice, and remember that Chinese investors cannot use margin to leverage companies with smaller net dollar shorts. At any rate, if the desire is to benefit from RMB appreciation, it seems a lot easier to leave the money in the bank.

In the end of course the proof is in the pudding. If you exclude government-forced outward investment, for example in their requirement that commercial banks hold part of their minimum reserves in dollars, I am very skeptical that we will see much Chinese enthusiasm for outward portfolio investment, QDII or otherwise, and that outflows will not be as high as you and others seem to think. Maybe by mid-year we can see whether the numbers are on track towards the $90 billion.

Chinawatcher, the QDII numbers are discussed (briefly) in Credit Suisse’s January 16 issue of Emerging Markets Economics Daily. By the way, I am not sure we should be too cynical about Credit Suisse’s motive’s and how the may have affected the numbers. All they do is compare launch prices of the funds with current market prices, so the ability to manipulate the numbers is pretty limited.

1) Just because the PBC wants to do something doesn't mean that they'll be able to do it. It's perfectly possible that the PBC will mess up, and you'll have interest rates in negative territory,

2) The nice thing about looking on an international market is that you have a huge number of companies to choose from. Also I was using assets and liabilities in a general sense including such things as customer base. If you want to benefit from the RMB appreciation, you look for companies in the US that are funded by exports to China, or companies in China that are funded from imports from the United States.

3) A lot about what happens this year with QDII is going to depend on this years events, and these are unpredictable. I don't recall anyone on 1/1/2007 predicting exactly where we would be on 12/31/2007.

Suppose tomorrow the PBC announces that the RMB has been revalued by 15%. Congratulations, you made your 15% on your banking account. Now what? You aren't going to get 15% next year. So what do you do? The fact that US stocks are now extremely cheap will change things and if there is a reval, I think there is going to be a huge interest in QDII in order to snap up extremely cheap US stocks.

Personally, I think one of two things are going to happen this year. Either the PBC is going to reval sharply or else you will have a burst of inflation in China since I think China has run out of sterilization mechanisms. Either situation is going to make QDII very attractive on 12/31/2008 even if they aren't that attractive on 1/1/2008.

Of course if there is an overnight 15% revaluation, that changes everything. I expect (and this part of the reason I think they ought to do it) that it would quickly cause a reversal of capital inflows and allow the PBoC to regain control of monetary policy. I agree with your final conclusion.