Understanding and accessing the Chinese equity market

Transcription

1 Understanding and accessing the Chinese equity market Although most of the Chinese equity market still remains in the hands of controlling parties and domestic investors, authorities have made significant progress in opening the market to foreign capital and increasing the tradable float outstanding meaning the Chinese equity market has the potential to become a top dominant force within global portfolios. Remarkable transformation Over the past two decades, the Chinese economy and financial markets have undergone a remarkable transformation and seen significant growth. More specifically, the Chinese equity market has grown from a once very rudimentary and closed market to one of the largest equity markets in the world. China has two stock exchanges, the Shanghai Stock Exchange (SSE) and the Shenzhen Stock Exchange (SZSE). The total market capitalization of all stocks listed on these two exchanges is approximately $3.3 trillion with a monthly turnover of $480 billion as of May Comparatively speaking, the Chinese domestic equity market itself is the third largest by total market capitalization in the world, behind the United States but very close to Japan. Including shares of Chinese companies listed in Hong Kong, China surpasses Japan as the world s second-largest market. 1 There are multiple share types providing access to Chinese companies. While all of them give access to companies whose main business proceeds are dervied from mainland China, they usually differ in one or more characteristics, such as domicile of the company, listing venue or the investor s geographic origin (domestic vs. foreign). Among the most well-known share types are A-shares, B-shares, H-shares, red chips, and P chips. In addition, some Chinese companies list their shares in the United States, London and Singapore. Figure 1 provides a more detailed description of Chinese share types. Although there are multiple share types providing exposure to Chinese-related companies, A-shares are the principal market for accessing the Chinese domestic growth story. However, this segment of the market has also been the most difficult one for foreign investors to access. The mainland Chinese stock exchanges were previously closed to foreign investors due to China s exercise of tight controls, which restrict the movement of capital into and out of the country. In an effort to mitigate this limitation, in 2002 Chinese authorities began implementing the Qualified Foreign Institutional Investor (QFII) system. 2 The QFII is a program that allows licensed foreign investors to buy and sell yuan-denominated A-shares on China s Shanghai and Shenzhen stock exchanges. In July 2012, in an effort to open China s market to overseas investors, and with the spirit of less control, more regulation, the China Securities Regulatory Commission (CSRC) promulgated some new QFII provisions. These provisions (1) encouraged the entry of overseas long-term capital by reducing the eligibility requirements for QFIIs, (2) increased operational convenience by permitting QFIIs to select multiple brokers, (3) expanded the scope of investment by permitting QFIIs to invest in inter-bank bond market and private placement bonds issued by small and medium enterprises, and (4) increased the shareholding ratio limit of all overseas investors from 20% to 30%. This white paper is based on research found in China Equity Market Opening up to the World by Deutsche Bank Research (June 2013).

2 Figure 1: Share types providing access to Chinese companies Name Currency Market Description A-shares Renminbi Onshore Companies incorporated in China and traded on the Shanghai and Shenzhen stock exchanges, A-shares are the largest Chinese share class. Investors are Chinese nationals and foreign institutional investors authorized under the Qualified Foreign Institutional Investors (QFII) program. B-shares U.S. dollar and Hong Kong dollar Onshore Companies incorporated in China and traded on the Shanghai (in U.S. dollars) and Shenzhen (in Hong Kong dollars) stock exchanges, B-shares were initially open only to foreigners, but are now also open to domestic retail investors. H-shares Hong Kong dollar Offshore H-shares are stocks of companies incorporated in China and traded on the Hong Kong stock exchange. N-shares U.S. dollar Offshore N-shares are stocks of companies incorporated in China but listed and traded on the New York Stock Exchange. L-shares British pound Offshore L-shares are stocks of companies incorporated in China, but listed and traded on the New York Stock Exchange. Red chips Hong Kong dollar Offshore Red chips are stocks of Chinese companies (often state-owned or state controlled) incorporated outside of China and listed in Hong Kong. P chips Hong Kong dollar Offshore P chips are stocks of Chinese companies (often run by private sector Chinese individuals) incorporated outside China but listed in Hong Kong. S-shares Singapore dollar Offshore H-shares are stocks of companies incorporated in China and traded on the Singapore stock exchange. Source: Deutsche Bank Research, China s Financial Markets A Future Global Force? as of 3/16/09. Then, in January 2013, speaking at the Asian Financial Forum in Hong Kong, Guo Shuqing, chairman of the CSRC, mentioned that as of the end of 2012, foreign shareholders had more than 11,000 trading accounts on the A-share market, holding an aggregate of 77.5 billion shares, accounting for 2.56% of total equity capital and 3.66% of total market capitalization on the A-share market. He pointed out that more than 200 QFII investors hold shares in 89.1% of all the listed companies. 3 He also indicated that quotas could be increased to 10 times the current level. 4 Figure 2 shows the evolution of the A-share market. Despite its size (and the aforementioned changes), the Chinese equity market remains underrepresented among global investors portfolios, mostly due to the foreign investment and free-float limitations found in the local market. Looking at the top 10 countries by free-float market capitalization within the MSCI All Country World Investible Market Index (ACWI IMI),China ranks number nine. 5 When compared by full market capitalization, the ranking for China improves to number six. Adding in the free-float market capitalization portion of the MSCI China A Market Index (which is not included in the MSCI ACWI IMI), China would move to number four in the Figure 2: Historical evolution of the A-share market November 2002 The China Securities Regulatory Commission (CSRC) and the People s Bank of China (PBOC) launched the QFII pilot scheme by jointly issuing the so-called Provisional Measures on Administration of Domestic Securities Investment of Qualified Foreign Institutional Investors (QFII) The CSRC, PBOC, and the State Administration of Foreign Exchange (SAFE) issued the so-called Administrative Measures on Domestic Securities Investment of Qualified Foreign Institutional Investors (QFII). April 2012 The QFII quota increased from $30 billion to $80 billion. December 2012 SAFE abolished the $1 billion quota limit per for sovereign wealth funds and central banks and allowed QFIIs to repatriate their principal and income generated, at the end of the lockup period. March 2013 The CSDSSL, the Chinese clearing and depository agency, announced that Hong Kong, Taiwan and Macau residents who live in mainland China can trade A-shares by opening domestic trading accounts The QFII quota increased from $4 billion to $10 billion. Source: Deutsche Bank Research as of June Understanding and accessing the Chinese equity market 2007 The QFII quota increased from $10 billion to $30 billion. July 2012 In an effort to open China s capital market to overseas investors, and in the spirit of less control, more regulation, the CSRC promulgated new QFII provisions. January 2013 CSRC Chairman Guo Shuqing said the RQFII/QFII quotas could be increased to 10 times the current level.

3 Figure 3: Global equity market openness 1.5% 11.4% 13.6% 14.0% 17.1% China (excluding securities listed overseas) China (including securities listed overseas) United States 22.8% 24.1% 28.0% 30.5% 30.6% 40.1% Russia India Japan Taiwan Mexico Brazil Korea United Kingdom 51.2% Germany Source: Deutsche Bank, International Monetary Fund, World Bank, Bank for International Settlements, CEIC Data, WIND and Haver Anlytics as of free-float ranking. Considering the full market capitalization of the China A-share market, then China would rank in second place, behind only the United States. Main characteristics of the China A-share market The Chinese domestic equity market has become one of the key players in Chinese economy since the establishment of the Shanghai and Shenzhen exchanges in Today, the Chinese stock market is one of world s largest in terms of market capitalization. There are 2,469 A-share companies listed on the Shanghai and Shenzhen stock exchanges with a total market capitalization of 24.5 trillion renminbi and a daily turnover of 200 billion renminbi. 1 The Chinese stock market has experienced profound development, but it is still relatively young given its main characteristic. Specifically, it is a relatively closed market, it is not mature in terms of investment philosophy and participant composition, and its share structure is less sophisticated than that of developed markets. Below we look at these characteristics in more detail. A relatively closed market. In regard to the Chinese domestic stock market being rather closed, at the end of 2012, the total value held by foreign investors accounted for only about 1.5% of total market capitalization, suggesting a rather low penetration of the Chinese domestic stock market, as Figure 3 illustrates. If we include foreign holdings in the Chinese stocks traded on offshore markets (including H-shares and red-chip stocks in Hong Kong, as well as other overseas listed Chinese stocks), the portion of Chinese stocks held by foreign investors increases to 11.4%, a level still much lower than those of other major emerging and developed markets. However, with the outlook of future acceleration of China s capital account liberalization, we expect the foreign investors holdings to be expanded to 4% by 2016, accompanied by the more aggressive QFII quota approvals and the enthusiasm of overseas investors. Investment philosophy and participants composition. The heavy involvement of individuals in daily stock trading is one of the main characteristics of the Chinese stock market. Figure 4 shows that individual investors, who hold merely 26% of total market capitalization, account for 78% of daily trading volume. Individual investors trading behavior is also the main source for the market s volatility. Our analysis shows that the 200-trading-day volatility of Shanghai Composite Index is 18%, as measured by the annualized standard deviation of the relative price change about 1.5 times the volatility of the S&P 500 Index and 1.6 times the volatility of the FTSE 100 Index. 1 Moreover, domestic institutions, including stock funds, are also frequently engaged in short-term speculation. Figure 4: Shareholder composition of the China A-share market Individuals, 26% Domestic security investment funds, 8% QFIIs, 1% Other institutions, including pensions, insurance companies, and banks, 65% Source: Deutsche Bank, China Equity Market Opening Up to the World, as of June Less sophisticated share structure. As an emerging stock market, the Chinese domestic stock market has less sophisticated structure in regard to products and derivatives, dividend payout ratio, active regulation involvement and abnormal anti-cycle performance. According to data compiled by Bloomberg, for example, the average dividend payout ratio of Shanghai Composite Index over the past three years was 34%, about 25% lower than that of S&P 500 Index and 50% lower than that of FTSE 100 Index. 1 Understanding and accessing the Chinese equity market 3

4 Getting exposure There are different investment vehicles available to obtain exposure to the Chinese market. At a higher level, we can classify these vehicles as either physical or synthetic. Physical exposure, which gives the investor direct ownership over the underlying asset, is gained by investing in securities such as common shares and depositary receipts. Many types of common shares provide access to Chinese companies. While all of them give access to companies whose main business proceeds are dervied from mainland China, as we have noted, they usually differ in one or more characteristics, such as domicile of the company, listing venue or the investor s geographic origin (domestic vs. foreign), as Figure 1, above, illustrates. Also included in the physical-exposure category are depositary receipts, which are U.S.-dollar-denominated negotiable instruments issued by a depositary bank that represent ownership of underlying ordinary shares of an issuer in a foreign jurisdiction. Two of the most common types of depositary receipts are American Depositary Receipts (ADRs) and Global Depositary Receipts (GDRs). ADRs are listed and traded in the United States, while GDRs are listed and traded in foreign markets (mainly London). Sometimes Chinese ADRs and GDRs are called N-shares and L-shares, respectively. to the involvement of the clearing house. An EIF provides exposure to an underlying index without the need to invest in the underlying constituents. An example of a China A-share market EIF is the CSI 300 Index future contract, which has been listed on the China Financial Futures Exchange since April 16, Other derivatives, such as China A-Share Access Product (CAAPs) and participatory notes (P-notes) also fall into this category. CAAPs and P-notes are both a type of financial derivative widely used by foreign investors to get access to the Chinese A-share market. CAAPs and P-notes are usually issued by registered foreign institutional investors (such as QFIIs) to investors overseas. Although these products provide exposure to the returns of the underlying stock or index, they do not entitle the holder to the ownership of the underlying securities, and thus expose the holder to counterparty risk. Finally, synthetic exposure includes exchange-traded funds (ETFs), a new and popular way to obtain China exposure. ETFs can provide low-cost access to a diversified basket of securities with the ease of a single trade. In addition, ETFs provide transparency, continuous pricing and liquidity during market hours. ETFs can gain access to China by employing any of the exposure methods and investment vehicles mentioned above. Synthetic exposure Synthetic exposure, which provides exposure to underlying asset returns without direct ownership, is typically gained by investing in derivatives such as swaps and futures. In some cases, then, synthetic exposure can also translate in additional risk in the form of counterparty risk. Included in this category are equity index swaps (EISs). An equity index swap is an over-the-counter bilateral agreement between two parties in which one party agrees to pay a fixed rate, usually LIBOR-based, plus the negative index return (if any) in exchange for receiving the positive returns of the index (mostly total returns) during a preset timeframe. EISs thus involve counterparty risk. Transactions are often governed by a standard International Swaps and Derivatives Association (ISDA) agreement. Also included in this category are equity index futures (EIFs). An EIF is an exchange-traded futures contract which is cleared and settled through a clearing house. EIFs are cash-settled and have, in theory, no counterparty risk due Restricted shares Another noteworthy phenomenon of the Chinese domestic stock market is the existence of restricted shares. Prior to reforms made to shareholder structure in 2005, only 40% of share capital could be freely traded, while the other 60% was owned by the state and others who were prohibited from selling. The 2005 reforms transformed these non-tradable shares into a new category called restricted shares, which are nonfloating and are gradually unleashed after a one- to threeyear lockup period. A similar rule was applied to stocks available through initial public offerings (IPOs). The nontradable share portion of total share capital in China is now merely 0.2%, and the non-floating shares ( locked ) weight is about 18%. The existence of sizable nonfloating shares could cause pressure on the stock market due to the liquidity dilution effect, as those previously non-floating shares were offered to shareholders at very low price, which provides the incentive to sell the shares on the market once unlocked. 4 Understanding and accessing the Chinese equity market

5 1 Source: Deutsche Bank, China Equity Market Opening Up to the World, as of June Licensed foreign investors given QFII status face the continuing risk that such status may be revoked by Chinese regulators if these investors do not observe applicable Chinese regulations Source: Deutsche Bank, MSCI and Markets Caps as of 12/31/12. Definitions The CSI 300 Index tracks the performance of 300 stocks traded on the Shanghai and Shenzhen stock exchanges. A derivative is a financial instrument that derives its value from another security or index. Dividend payout ratio is the fraction of net income a firm pays to its shareholders in dividends. Free float refers to the number of a company s outstanding shares that are available to the public for trade. Stocks with small free float tend to be more volatile because there are only a limited number of shares that can be bought or sold in the event of major trading news. The FTSE 100 Index tracks the performance of the the 100 companies listed on the London Stock Exchange with the highest market capitalization. A future is a financial contract obligating a buyer to purchase an asset (or a seller to sell an asset) at a predetermined future date and price. LIBOR, or the London Interbank Offered Rate, is a widely used benchmark for short-term taxable interest rates. The MSCI All Country World Investible Market Index (ACWI IMI) tracks the performance of 9,000 securities across all market capitalizations and sectors in 45 developed and emerging markets. The MSCI China A Market Index tracks the performance of all China A-shares listed on the Shanghai and Shenzhen stock exchanges. The S&P 500 Index tracks the performance of 500 leading U.S. stocks and is widely considered representative of the U.S. equity market. The Shanghai or SSE Composite Index tracks the performance of all stocks (A-shares and B-shares) that are traded on the Shanghai Stock Exchange. Standard deviation is often used to represent the volatility of an investment. It depicts how widely an investment s returns vary from the investment s average return over a certain period. A swap, a type of derivative, is an agreement between two parties to exchange sequences of cash flows for a set period of time. One cannot invest directly in an index. General disclosure (wealth management) Deutsche Bank means Deutsche Bank AG and its affiliated companies. Deutsche Asset & Wealth Management represents the asset management and wealth management activities conducted by Deutsche Bank AG or its subsidiaries. Clients are provided Deutsche Asset & Wealth Management products or services by one or more legal entities that are identified to clients pursuant to the contracts, agreements, offering materials or other documentation relevant to such products or services. 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