what QFII is

The acronym stands for Qualified Foreign Institutional Investor.  It’s the general name for any formal system for limiting foreigners’ access to domestic capital markets.

QFII arrangements are par for the course in emerging markets. They work as follows:

–A foreign investor applies to the government for permission to enter the market.  The application process itself can be complicated and time-consuming, and acts as a filter to weed out the less resolute.

–The foreigner must typically have a certain length of experience in the asset management business and a certain minimum amount of assets under management.

–A successful applicant is subject to a number of constraints.  Typically, he is given an investment quota,  a specified amount of money that must remain in the country.  Minimum holding periods for any securities purchases may be specified.  Certain industries may be off-limits.  Individual and aggregate maximum levels of foreign ownership of given enterprises may also be specified.

In China’s case, the QFII program has been in place for almost a decade.  QFIIs must have been in business for at least five years, have a clean regulatory record in the markets where they already operate, and have a minimum of $5 billion in assets under management. Foreigners can only buy equities.  In the aggregate can’t own more than 20% of a domestic company’s stock. Until this April, the maximum investment quota for any QFII was $30 billion.

why restrict foreign access to markets?

Every country in the world limits foreign access to capital markets in one way or another.  Control of companies thought vital to the national interest–transport, telecom and media are the usual suspects–is almost always legally barred to foreigners.

Bids in non-vital sectors are also often subject to government regulatory review. These cases often express the national ego rather than economic sense.   It isn’t that long ago, for example, that France disallowed Pepsi’s bid for Danone on the grounds that the yogurt company is a national treasure.  Mainland Chinese companies have extreme difficulty in getting government approval for purchases in the US.  In the early 1980s Washington rejected Fujitsu’s bid for Fairchild Semiconductor, on the grounds that a foreigner shouldn’t control a defense-related manufacturer–but then approved its sale to a French firm, Schlumberger (the purchase worked out very badly, by the way).

Emerging countries have more genuine worries.

–They fear that without ownership restrictions wealthy foreigners will buy the crown jewels of the local economy at bargain-basement prices.  Foreigners have more money.  And they may understand the long-term potential of companies better than locals.

–Emerging nations also have a vivid example of the risks in having open markets that occurred during the Asia financial crisis of the late 1990s. At that time, hedge funds tried to destroy the perfectly healthy Hong Kong economy through massive shorting of the currency and of the local stock market.   It took the deep pockets of mainland China plus the Hong Kong government’s purchase of a quarter of that market’s outstanding shares to see off the threat.

changes to the China system

In April, the individual QFII investment quota was raised from $30 billion to $80 billion.

This week, the China Securities Regulatory Commission has proposed further loosening of the rules:

–the minimum assets under management would be lowered from $5 billion to $500 million, thereby allowing many hedge funds to enter the market for the first time

–the cap on aggregate foreign ownership of companies would be raised from 20% to 30%, and

–in addition to equities, QFIIs would be allowed to buy bonds and stock index futures.

this is good news…

…because it represents another step in opening the capital markets of the world’s second-largest nation to economic forces, rather than simply local vested interests.

…and bad

Invariably, countries take measures like this when they feel the local market needs the inflow of funds that foreigners can provide.  It’s typically during weak economic times when the local government senses that domestic investors are much more likely to be sellers of local securities than buyers.

So while the moves by Beijing should be welcomed by long-term investors, they also seem to me to signal that tough sledding is ahead in the near term for holders of Chinese A shares.  For most of us, who are presently excluded from the market anyway, the relevant information is confirmation of what we have most likely already suspected– that corporate profit announcements from China over the next several months will likely be much poorer than the consensus is expecting.