My Blog

November 30, 2007

Yuan Li, a spokesman for the China Insurance Regulatory Commission, said yesterday at a conference that the twenty mainland insurers that have received QDII licenses are expected to invest mostly in Hong Kong stocks.  The insurance companies together have about $400 billion of assets, and since July they have been permitted to invest as much as 15% of their assets abroad – before that it was 5% (although my understanding is that none of them are anywhere near their limits).

QDIIs have been a hot topic since China Southern Fund Management launched the first successful mutual fund QDII on September 12.  They expected to raise RMB 15 billion during the just-over-two-week subscription period to fill their QDII quota, but on their first day of subscriptions they received RMB 50 billion in orders (and closed subscriptions that day).  SAFE subsequently doubled their quota to RMB $4 billion.

Two weeks later China Asset Management received orders of RMB 60 billion for the launch of their own QDII, whose quota was then also doubled, to $5 billion.  The first QDII launch was actually in October of 2006, by Hu’an Fund Management, but they were only able to $200 million of their $500 million quota.  This year’s crop was a lot more successful.  By the way not everyone in China can be a client of a mutual fund QDII.  The minimum investment is RMB 300,000 (about $40,000), so it leaves out nearly all of China’s many small investors. 

I am not sure of the exact numbers but I think that there are ten approved QDIIs, not counting the insurance companies (eight fund management companies and two securities firms, CICC and China Merchants), and by the end of the year there will be around three more approved, to raise altogether about $20-30 billion.  Next year most commentators expect there to be another $90 billion in funds raised to invest abroad through the QDII program – there are around fifteen fund managers and three securities firms that are slated to get approval.

In principle this is an unalloyed good thing.  Not only does it help internationalize Chinese markets and give Chinese firms experience managing money in other markets, but anything that reverses capital outflows helps the PBoC manage the huge inflows China is experiencing through its trade and capital accounts.  Money leaving China this way is netted out of the inflows that have to be converted into currency or central bank bills, and that is a huge relief for a central bank struggling to moderate its wild money expansion.

However given the currency situation in China I wonder how these QDII funds can possibly keep their clients happy.  Because of the minimum investment size QDII clients are supposed to be sophisticated and knowledgeable about the benefits of diversification, but with the RMB expected to rise by anywhere from 7% to 10% over the next year (with only upside risk), and deposits earning nearly 4%, QDIIs are going to have to be very profitable to jump the low-risk 11-15% hurdle they will have to make in dollars just to break even relative to RMB bank deposits. 

Diversification is a good thing, of course, but if all it means is that investors lose money, it is hard to see why anyone would want it.  At any rate from what I understand most QDII money is going to Hong Kong stocks, and the Hong Kong stock market has become pretty highly correlated with the mainland stock markets, so it is unlikely that they will provide much of a hedge, although on the other hand there is a built-in currency hedge for the Hong-Kong-listed stocks of mainland companies.  A rising RMB should translate into an automatic rise of their net asset values in HK dollars, which may then result in an automatic increase in their HK share prices.

If QDIIs are conservatively managed they are most likely going to underperform local investment alternatives.  In that case instead of more money pouring into QDIIs next year I wonder if we won’t see disgruntled investors begin to withdraw their investments as their returns significantly underperform simple bank deposits.  We may see net redemptions next year, rather than more money going into QDIIs.

On the other hand If QDII managers feel compelled to beat the currency-related hurdle to keep their investors, there is the danger that they stretch a little too far for yield and take some ugly risks.  If as a manager you expect prudent investing will lead to redemptions, does that create an incentive to go out too far on a limb?  I think it might, at least in some cases, and I don’t doubt there will be some dodgy ideas peddled to fund managers.  However a nasty performance for one of these QDIIs could sour the whole market, at least in the short term. 

It is hard to see why investors should be taking money out of the country much longer when the best game in the world seems to be to bring money into China, especially as the pressure for RMB appreciation increases.  If QDII investors do reverse their earlier decision, the monetary benefits of the QDII program could actually reverse next year as investors bring their money back home, and with reserves expected to grow anyway by another huge amount, this reversal will only make matters worse.  This might not necessarily apply to the insurance company QDIIs, who may have a different set of incentives, but even for them several quarters of underperformance should at least retard the growth of their QDII appetite.

Comments (5) for "Will QDII make a difference ...

The reason for QDII is that Western stocks are very cheap in comparison to Shanghai stocks based on price/earning ratios. There are very interesting things happen with respect to the risk/reward curve that I haven't quite figured out. By Twofish - 11/30/2007 4:24 AM

The reasons for establishing the QDII were first, to help internationalize the Chinese financial system and second, to encourage controlled capital outflows. It was only the huge run-up in 2006 and especially 2007 in the mainland stock markets that made the Hong Kong stocks cheap. PEs abroad may be lower than in China, but I don't think anyone in China expects that foreign markets will surge until their PEs match those in the mainland, and anyway most QDII is going to shares listed abroad (mainly in HK) of mainland companies. I think when and if that demand is satisfied, QDIIs will stop becoming interesting until the RMB has a appreciated a lot more. By Michael Pettis - 11/30/2007 6:02 PM

[q]I don't think anyone in China expects that foreign markets will surge until their PEs match those in the mainland[/q] They won't, which means that foreign markets are going to be a sink for Chinese money for a long time. The runup in Shanghai markets is due to the lack of other options, and global markets provide a sink for the excess money. [q]anyway most QDII is going to shares listed abroad (mainly in HK) of mainland companies. I think when and if that demand is satisfied, QDIIs will stop becoming interesting until the RMB has a appreciated a lot more.[/q] I'm not so sure. There is a very large element of "gambling mentality" in Shanghai stock investors, and QDII provides a larger menu of items to gamble with. In any event, as the RMB appreciates, overseas stocks are going to more attractive resulting in higher outflows. BTW, I've been going through your book, and I must congratulate you on one of the most brilliant pieces of financial literature I've ever read. I've been trying to use the model that your presented to analyze the flows between the PRC and the rest of the world, since it isn't clear to me right now whether they result in an inverted structure (bad) or a coorelated structure (good). You have hot money flowing in buying bonds which I think will be balanced by money flowing out buying equities. What happens when liquidity contracts? Also, one thing that has changed the analysis is that this is the first time in history that there are been a transfer of investment from an emerging market to a developed one, and this is because "China is big." That I think changes the analysis a bit. By Twofish - 12/2/2007 1:23 AM

It is interesting how much private capital will flow out when Rmb is heavily undervalued and local asset reflation process unstopped the 12% almost risk free USD return( 7% FX +4-5% rates ) is probabaly too high a hurdle to beat in global market. ( top rated Global Macro hedge funds barely do that but stil runl signficant volatility in return). There will probabaly a backlash redemption in QDII when A share stabilizing and bounding back in 2008 By isaac - 12/2/2007 10:22 AM

Twofish, thanks a lot for the comments on my book. Coming from you I feel honored. Two points. First, I think that there have been other cases of capital flows from developing countries to developed ones, although admittedly under very different conditions. For example during the 1980s there was a large net transfer from most Latin American countries to the developed world (in fact I think Brazil had the second largest trade surplus in the world, after Germany, for much of that period). I believe Japan may have also done so during parts of its developing history, although I am not so sure, and I think it was a feature of the Asian tigers for at least part of their developing history. But generally you are right. For example I think both Hobson and Lenin assumed that capital flows from rich countries to poor countries were almost part of the definition of the relationship between rich and poor. Second, I think on its external account, China’s balance is highly correlated. An Asian-style crisis is not in the cards at all in my opinion, at least in the near future. I think for China we need to be more concerned about an earlier model of crisis – that of the US in the 19th Century. When we look at China’s domestic “balance sheet” the inverted structures (and there are many) have to do with the banking system, and with a series of self-reinforcing mechanisms between the “asset” and “liability” sides of the economy. These may end up looking a lot like the overproduction cycles and bank runs that were common in the 19th Century, especially in the US. In fact I have been thinking for a while of writing an article or short book arguing that the next big series of financial crisis are not going to be 21st Century crises at all (as you may remember the Mexican crisis of 1994 was popularly called the first crisis of the 21st Century) but rather 19th Century ones. Isaac, I agree. Let’s see what happens next year with QDII. By Michael Pettis - 12/2/2007 8:28 PM