We looked at the QFII and RQFII schemes in the first issue of KWM Connect – the process by which particular types of foreigners invest in the Mainland’s securities market. In this issue, we examine the mirror image of that flow of capital, being Mainland institutional investors investing offshore. China’s expenditure on global outbound M&A has grown rapidly since 2006, expanding its presence across the world. The Qualified Domestic Institutional Investor (QDII) scheme sits alongside that development, allowing a range of Mainland institutional investors to trade offshore in a growing array of financial instruments.
QDII – ON THE GROUND
The QDII scheme enables domestic institutional investors with a QDII licence and quota approved by the relevant Chinese regulatory authority, to invest in offshore markets. Each QDII is granted a specific quota by the State Administration of Foreign Exchange (SAFE). Unlike the QFII or RQFII scheme, there is no cap on the aggregate QDII quota.
Milestones of QDII scheme
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The chart below shows the basic operation of the QDII regime:
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- The QDII regime requires the relevant QDII institution to appoint an onshore custodian to manage the custodian accounts and supervise the investment activities of the QDII institution.
- The onshore custodian may appoint an offshore custodian to manage the offshore custodian accounts.
- The chart includes the offshore product provider and clearing system for completeness.
- No SAFE approval is required for remittance of QDII funds within the approved quota of the relevant QDII institution.
DIVIDED REGULATION – A KEY FEATURE OF THE QDII SCHEME
As of 26 June 2013, there were 112 QDII institutions holding investments valued at USD85.857 billion, including 29 commercial banks, 47 securities companies and fund managers, 28 insurance companies and 8 trust companies.4
Although the QDII scheme is commonly perceived as a single unified regime, it is actually divided into four broad categories depending on the type of QDII institutions and the applicable regulatory regime.
QDII securities companies and fund managers enjoy the largest market share of all QDII institutions because they are subject to a less restrictive regulation under the CSRC QDII regulations.
Each regulator has issued rules for the institutions it regulates, resulting in the following differences between regimes.
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Differences in sources of funds and onshore selling activities
Due to restrictions under the PRC Securities Law, a QDII institution is required to repackage an offshore manufactured investment product as its own QDII product for sale to its PRC investors. China’s regulators impose different requirements on QDII institutions with respect to:
- the channels through which QDII institutions may raise funds onshore;
- the onshore selling activities that QDII institutions may undertake; and
- the investment criteria that onshore investors must satisfy.
Unlike the other types of QDII institutions, insurance companies are not allowed to raise funds onshore by issuing QDII products to onshore investors. Under the current CIRC regulatory regime, a QDII insurance company is only permitted to invest its proprietary funds (i.e. onshore funds it raises through offering of insurance products to onshore investors in its ordinary business) in its offshore QDII investments.
The following table highlights the main differences between the QDII regulations applicable to onshore QDII products launched by QDII banks, trust companies and fund managers/securities companies:
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Differences in permissible offshore investments
As a result of the different QDII regulatory regimes, different categories of QDII institutions are subject to different types of permissible offshore investments. A summary of the key differences is set out below:
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Offshore product sellers must be aware of these differences when dealing with different types of QDII counterparties and must verify the permitted investment scope applicable to the relevant QDII counterparty. Table 1 sets out a sample list of documents that an offshore product seller should ask its QDII counterparty to provide.
Table 1 – due diligence document checklist
- business licence
- financial permit (in the case of QDII banks)
- derivatives licence (in the case of QDII banks and QDII trust companies)
- QDII licence and the permitted investment scope approved by the relevant regulator
- QDII quota granted by the SAFE
- the articles of association
NEW QDII PROSPECTS
Cross-border lending structure using the QDII scheme
Cross-border loans are subject to strict foreign exchange control regulations under PRC law. The QDII regime is a legitimate channel to facilitate capital movements from onshore to offshore without triggering a regulatory approval. Care must be taken in structuring onshore selling of QDII products where the proceeds sourced from a PRC corporate are invested in a product issued by, or lent to, an offshore party related to that PRC corporate. A transaction must not be designed with the primary objective of circumventing the PRC’s foreign exchange control on capital movements.5
This structure involves regulatory risk that an offshore entity must be aware of:
- There is currently no specific restriction on a PRC corporate purchasing a QDII product linked to an offshore investment product. However, if such a product embeds a derivative, the PRC corporate must have capacity to enter into a derivative transaction.
- If the QDII institution is a commercial bank, the QDII bank should also (i) ensure that the PRC corporate has a “genuine business need” to buy the QDII product and (ii) conduct a risk assessment on a per transaction basis to make sure the transaction is suitable for the PRC corporate.
- The SAFE may treat the transaction as a disguised form of “foreign guarantee/ security” arrangement provided by a PRC corporate in favour of the offshore lender. Provision of a foreign guarantee/ security by a PRC corporate is subject to the SAFE case-by-case approval and registration (see Table 2 for a summary of the rules in relation to a PRC corporate providing a “foreign guarantee/security” for debts of a third party).
Table 2 – rules relating to a foreign guarantee/security provided by a PRC corporate for debts of a third party
- in general, the SAFE’s case-by-case approval is required
- can only provide foreign guarantee/security for the debts of its directly or indirectly owned onshore or offshore subsidiaries
- the debtor must have positive net assets
- case-by-case registration with the SAFE
- prior verification by the SAFE on a case-bycase basis is required when making payments under the foreign guarantee/security
Impact of proposed mutual recognition of funds between Hong Kong and the Mainland
The Securities and Futures Commission (SFC) in Hong Kong announced in January 2013 that it was working with the CSRC on a plan to launch mutual recognition of funds between Hong Kong and the Mainland. According to the SFC, when the mutual recognition scheme is launched, qualified SFC-authorised funds domiciled in, and operating from, Hong Kong will enjoy the status of “recognised Hong Kong funds”, and qualified Mainland funds will enjoy the status of “recognised Mainland funds”. These recognised funds can then obtain authorisation and be sold directly in the other’s market.
The market anticipates that the mutual recognition of funds between Hong Kong and the Mainland will have a direct impact on the existing QDII scheme. Currently, the only way for international fund managers to target PRC individual investors is through cooperation with an onshore fund manager which has a QDII licence and quota. The cooperation is in the form of either a QDII sub-advisory arrangement or an equity holding in a QDII mutual fund manager.
The proposed mutual recognition of funds between Hong Kong and the Mainland will provide international fund managers direct access to PRC retail investors.
A working group comprised of representatives from the SFC, the CSRC and the Asset Management Association of China, is currently working to formalise the details for the proposed mutual recognition of funds. We understand that the key issues to be resolved relate to:
- investor protection rules;
- application of the foreign exchange controls under the current capital control rules; and
- the precise approval criteria to be adopted for the authorisation process in both Hong Kong and the Mainland. It is expected that the detailed rules will be issued by the end of 2013.
It is expected that the detailed rules will be issued by the end of 2013.
Guo Shuqing, the previous Chairman of the CSRC, announced in January 2013 that China planned to launch a pilot scheme for qualified domestic individual investors (QDII2), which would enable PRC individuals to invest directly in offshore markets (commonly known as the “through train”).
While the detailed rules have not yet been published, there has been public discussion6 as to what the QDII2 scheme might look like. Hong Kong is expected to be the first offshore market for the trial of the QDII2 scheme. Qualified individual investors will be allocated an investment quota through their Mainland securities companies. The first tranche of quota will likely be in aggregate not more than USD50 billion so as not to exceed the aggregate outstanding available investment quotas of the relevant Mainland securities companies. The CSRC will issue rules in relation to the criteria for “qualified” individual investors.
It is expected that QDII individual investors may only invest in shares listed on the Hong Kong Stock Exchange under the pilot scheme.
The launch of the QDII2 scheme will potentially impact the Hong Kong market in the following ways:
- a change in the mix of “popular” stocks – PRC individual investors have traditionally preferred investing in small-to-mediumsized and high-growth companies rather than large-capitalisation stocks; and
- Mainland securities companies and brokerages which have a base in Hong Kong will become more competitive because of their extensive Mainland client base.
The QDII2 scheme is expected to be launched by the end of 2013.
The State Council announced in early May 2013 that it will launch a plan this year to make Renminbi fully convertible under capital account. China will establish a comprehensive system for domestic individuals’ investments in Hong Kong utilising the “through train” which was first raised as a possibility in 2007. The QDII2 scheme will be a transitional arrangement until the “through train” scheme is fully implemented.
We believe that Hong Kong will continue to be the most popular destination for QDII investors. PRC insurance companies are encouraged under the 2012 CIRC Implement Rules7 to set up asset management companies in Hong Kong in order to invest in the Hong Kong market. As of the end of June 2013, nine insurance companies8 have set up their asset management subsidiaries in Hong Kong. We expect a continuing trend in the use of QDII platforms by QDII institutions.