China has decided to learn the ropes of global investing and Hong Kong is the place to help them do it

With anything up to US$1.6 trillion sitting idly in banks and the world’s biggest foreign exchange reserves of US$856 billion, China has decided to learn the ropes of global investing. And Hong Kong looks like the place to do it – adding a powerful new dimension to the city’s role as a key international financial centre.

China announced new regulations in April setting up a long-awaited Qualified Domestic Institutional Investor (QDII) scheme, for the first time allowing corporations and individuals to send money abroad for investment purposes. Previously, corporations could only hold foreign currencies as part of their business operations.

Under new rules issued by the central People’s Bank of China, banks and mutual will be allowed to put money to work abroad for their corporate and individuals clients.

The old restrictions were intended to prevent big outflows of capital which could destabilise China’s economy, but have also led to a huge stockpile of foreign exchange reserves and criticism about an undervalued currency and large trade surpluses from key trade partners the US and EU.

New role for HK

As China opens up, it is creating a whole new financial centre role for Hong Kong, which had been mainly a conduit for inward investment of foreign money into the mainland.

The upside for Hong Kong is huge as billions of dollars of Chinese money is finally freed to seek better returns abroad, say investment professionals.

“A natural target for all that money is Hong Kong. That’s the first place that people in China think about. They are not going to put it in Japan and Singapore is too far away,” said Brook McConnell, President of mutual fund house South Ocean Management.

The fact that China has allowed QDII to happen may in part be due to its confidence in Hong Kong’s financial system, says Mr McConnell. “It has institutions that China can rely on. They are flush with cash and they are solid,” he said.

“I think it is mutually beneficial to both sides and its going to last for a long time. It’s going to be very exciting in the next 10 years.”

The amount of capital flows from China to Hong Kong and other developed financial markets may be slow at first but should pick up speed as Beijing gets more confidence in the QDII system.

“I think it is just the tip of a real big ice berg,” said Mr McConnell.

Long term benefits

About US$2 billion QDII money may be invested in Hong Kong stocks this year but should rise to about US$9 billion by 2010, according to Deutsche Bank research.

“Hong Kong’s stock exchange will likely be a long-term winner of strong capital inflows from China,” Deutsche says.

The announcement of regulations setting the framework for a QDII scheme is just the latest in a series of such reform steps in the last few months.

The Chinese cabinet, the State Council, has already approved regulations for the country’s US$25 billion National Social Security Fund to invest overseas. Insurance giants China Life and Ping An have also been given quotas.

 “I foresee more and more investment activities will be done through Hong Kong,” said Y.K. Chan a fund manager with Phillip Asset Management. “Hong Kong, at least in the foreseeable future, will be one of the most important centres to learn international rules and practices.”

China now has the world’s fourth biggest economy after the US, Japan and Germany and needs to find ways for corporate and individual investors to find bigger returns as it shifts focus from exports to domestic consumption.

Deposits in Chinese banks earn just 2.25 per cent a year, five-year government bonds yield just 2.1 per cent and China’s domestic stock markets have only just recovered in the last few months from an eight-year low.

Better rewards

Investors in Hong Kong assets have been better rewarded. Bank deposits in the city can earn 3 per cent or higher, five-year government bonds yield 4.3 per cent and the stock market has just hit five-year highs, though some blue chip stocks are still offering attractive dividend yields of above 4 per cent.

The reforms also mean that Chinese investors will for the first time be able to buy shares in some of the country’s biggest and best companies which are listed in Hong Kong but not domestically. Among such names are dominant cell phone player China Mobile, oil giant PetroChina and China Construction Bank, the country’s third biggest lender.

Of course, some of China’s investment money will go further afield into asset classes such as US treasury bonds or European stocks. But once again Hong Kong, which boasts a wealth of fund management talent, can play an important intermediary role.

Hong Kong’s sound legal system and freedom of capital flows have meant it has long offered a wide array of global investment products. The new rules mean the banks and fund houses offering those products just gained a new potential market of 1.3 billion people.