The China Securities Regulatory Commission (CSRC) announced its plans to further increase access to the Chinese capital markets for foreign investors. A draft of the planned regulations published by the CSRC promises a more efficient application process, grant more types of investable securities and bigger investment quotas. This breeze of liberalization is particularly beneficial for the private investment funds operated by foreign asset management (AM) companies. These funds, organized as wholly foreign-owned enterprises (WFOE), are one of the main instruments that allow foreign institutions to tap one of the fastest growing asset management industries in the world.
This article will attempt to explore the prospects of foreign players to enter the asset management industry. At first, it summarizes the immense potential inherent in Chinese AM industry. Then, the article will discuss the Qualified Foreign Institutional Investor (QFII) program and evaluate the strengths and weaknesses of WFOE. It shows that, despite the vast profits promised by the AM market, there are several structural constraints that reduce foreign firms to be marginal players.
Chinese asset management market experienced explosive growth in the previous decade and is expected to continue to expand. Fuelled by the growth of assets possessed by high net worth individuals, total investible financial assets of Chinese consumers are projected to reach 38 trillion USD in 2022, showing an almost 20% CAGR from 22 trillion in 2019. The wealthier consumers base will inevitably propel the asset management industry in China. Oliver Wyman expects a CAGR of around 10% over the next three years that would result in an AUM of 14 trillion USD in 2022. This will put China as the world’s second-largest wealth management market with 15% of the global share.
Another factor is that Chinese asset management industry is set to experience a substantial transformation. Currently, “quasi” asset managers, such as bank wealth management products (BWMPs) and trusts, hold around 60% of total AUM, whereas more “conventional” AM players, like private funds, mutual funds, and insurance AMs, trail their “quasi” counterparts with a 40% share. BWMPs in China are often used to provide “off balance sheet” corporate loans to ease the burden of capital reserve requirements. Thus, investments in BWMPs are essentially fixed-income exposures that frequently feature return/principal guarantees. With more strict regulations to be applied to BWMPs and the moderation of China’s economic growth rates, “quasi” to “traditional” AM ratio is bound to move to more equitable 50/50 split in 2022. Thus, the consumer wealth is projected to move from deposits and RE sector to financial assets, leading to an increased inflow of assets into NAV-based mutual and private funds and move out of BWMPs.
This article will attempt to explore the prospects of foreign players to enter the asset management industry. At first, it summarizes the immense potential inherent in Chinese AM industry. Then, the article will discuss the Qualified Foreign Institutional Investor (QFII) program and evaluate the strengths and weaknesses of WFOE. It shows that, despite the vast profits promised by the AM market, there are several structural constraints that reduce foreign firms to be marginal players.
Chinese asset management market experienced explosive growth in the previous decade and is expected to continue to expand. Fuelled by the growth of assets possessed by high net worth individuals, total investible financial assets of Chinese consumers are projected to reach 38 trillion USD in 2022, showing an almost 20% CAGR from 22 trillion in 2019. The wealthier consumers base will inevitably propel the asset management industry in China. Oliver Wyman expects a CAGR of around 10% over the next three years that would result in an AUM of 14 trillion USD in 2022. This will put China as the world’s second-largest wealth management market with 15% of the global share.
Another factor is that Chinese asset management industry is set to experience a substantial transformation. Currently, “quasi” asset managers, such as bank wealth management products (BWMPs) and trusts, hold around 60% of total AUM, whereas more “conventional” AM players, like private funds, mutual funds, and insurance AMs, trail their “quasi” counterparts with a 40% share. BWMPs in China are often used to provide “off balance sheet” corporate loans to ease the burden of capital reserve requirements. Thus, investments in BWMPs are essentially fixed-income exposures that frequently feature return/principal guarantees. With more strict regulations to be applied to BWMPs and the moderation of China’s economic growth rates, “quasi” to “traditional” AM ratio is bound to move to more equitable 50/50 split in 2022. Thus, the consumer wealth is projected to move from deposits and RE sector to financial assets, leading to an increased inflow of assets into NAV-based mutual and private funds and move out of BWMPs.
So, it is natural that China presents an extremely attractive market that lures global asset managers. On the surface, the potential 14 trillion USD market promises a source of profits ripe to easy harvest if one is able to build a business at scale. However, there are reasons why the penetration level by foreign players is still inadequate.
One of the main predicaments that hampered the involvement of foreign firms is a harsh regulatory framework. Previously, the entrance of foreign players into the Chinese market was mostly possible only through the establishment of a minority joint venture with local firms by setting up a mutual fund management business. This was done through the Qualified Foreign Institutional Investor (QFII) and Qualified Foreign Limited Partner (QFLP) programs, introduced by the CSRC in 2002. The QFII enabled foreign institutional investors that conformed to certain qualification requirements to invest in a limited range of Chinese securities.
Although a significant breakthrough, at the time, the QFII granted only a severely restrained exposure to the market. A number of restrictions were present such as a ceiling for a single QFII quota, difficulty of capital transfer, prolonged lock-up periods, and limited investment options. A foreign investor could only acquire A-shares, treasuries, convertible and enterprise bonds that were listed on China’s stock exchanges. Also, a QFII could not hold more than a certain threshold of total outstanding shares of the listed company.
Between 2002 and 2016, the QFII program experienced a gradual process of relaxation of these limitations, general simplification of the application process, and expansion of the list of investable securities. In 2016, the CSRC decree granted to foreign companies’ a right to establish an investment management wholly-foreign owned enterprise (IM WFOE) and register for a private fund manager program (PFM) to receive a PFM qualification. Thus, a foreign company now has an alternative of opting out from creating a joint-venture with a local firm. The WFOEs are allowed to set up open-ended “private investment funds” and raise capital from 200 qualified individuals and institutions. Each contribution from an investor should be at least one million RMB or approximately 145,000 USD. At present, the WFOEs are authorized to provide their services and fund products to qualified professional investors only, whereas the joint-venture fund can also sell its products to retail investors. This might change as the CSRC is planning to extend the PFM holders’ service to cover the retail market by 2021.
However, an array of truly groundbreaking reforms arrived only recently, between the end of 2018 and the beginning of 2019. Firstly, the CSRC decided to raise the permitted ceiling of foreign ownership of mutual fund management companies up to 51%, which means the possibility of majority control. The CSRC regulation draft proposed that this threshold will be abolished altogether within the next three years. In addition, the QFII now can engage in financial futures and options trading and participate in bond repurchase agreements. The commission also demonstrated its plans to loosen the margin call terms, broaden a list of assets allowed as collaterals, and make the margin trade and short selling easier. In general, the proposed changes will significantly decrease the disadvantage of foreign investors, thus levelling the field.
One of the main predicaments that hampered the involvement of foreign firms is a harsh regulatory framework. Previously, the entrance of foreign players into the Chinese market was mostly possible only through the establishment of a minority joint venture with local firms by setting up a mutual fund management business. This was done through the Qualified Foreign Institutional Investor (QFII) and Qualified Foreign Limited Partner (QFLP) programs, introduced by the CSRC in 2002. The QFII enabled foreign institutional investors that conformed to certain qualification requirements to invest in a limited range of Chinese securities.
Although a significant breakthrough, at the time, the QFII granted only a severely restrained exposure to the market. A number of restrictions were present such as a ceiling for a single QFII quota, difficulty of capital transfer, prolonged lock-up periods, and limited investment options. A foreign investor could only acquire A-shares, treasuries, convertible and enterprise bonds that were listed on China’s stock exchanges. Also, a QFII could not hold more than a certain threshold of total outstanding shares of the listed company.
Between 2002 and 2016, the QFII program experienced a gradual process of relaxation of these limitations, general simplification of the application process, and expansion of the list of investable securities. In 2016, the CSRC decree granted to foreign companies’ a right to establish an investment management wholly-foreign owned enterprise (IM WFOE) and register for a private fund manager program (PFM) to receive a PFM qualification. Thus, a foreign company now has an alternative of opting out from creating a joint-venture with a local firm. The WFOEs are allowed to set up open-ended “private investment funds” and raise capital from 200 qualified individuals and institutions. Each contribution from an investor should be at least one million RMB or approximately 145,000 USD. At present, the WFOEs are authorized to provide their services and fund products to qualified professional investors only, whereas the joint-venture fund can also sell its products to retail investors. This might change as the CSRC is planning to extend the PFM holders’ service to cover the retail market by 2021.
However, an array of truly groundbreaking reforms arrived only recently, between the end of 2018 and the beginning of 2019. Firstly, the CSRC decided to raise the permitted ceiling of foreign ownership of mutual fund management companies up to 51%, which means the possibility of majority control. The CSRC regulation draft proposed that this threshold will be abolished altogether within the next three years. In addition, the QFII now can engage in financial futures and options trading and participate in bond repurchase agreements. The commission also demonstrated its plans to loosen the margin call terms, broaden a list of assets allowed as collaterals, and make the margin trade and short selling easier. In general, the proposed changes will significantly decrease the disadvantage of foreign investors, thus levelling the field.
Still, there are several conundrums that obstruct the actual realization of these plans into a real-world expansion of foreign firms. Despite having an opportunity of transforming their minority holdings into a majority, to date, none of the minority positions in 19 currently active mutual fund companies were converted to controlling stakes. It is rumoured that HSBC, JPMorgan Asset Management, Morgan Stanley and Atlanta-based Invesco are already developing the deals to undertake a majority control in their respective joint-ventures with local Chinese firms. But an escalation of the trade war between the US and China put the completion of these deals on indefinite hold.
Moreover, a conversion of a minority stake into a majority may become a difficult task to exercise as the local partners in joint-ventures often possess substantial bargaining capacity. The Chinese firms in mutual management companies are responsible for such key functions as managing the local distribution network and operational infrastructure, provision of brand recognition, and give access to a strong customer base.
Therefore, a decision to form a WFOE instead of participating in a joint-venture with a Chinese local partner implies that the foreign investor will not be able to enjoy the aforementioned benefits. In fact, FSA reports that the WFOE managers deem the distribution as one of their principal weaknesses that is difficult to handle. In addition, Caixin Global claims that Chinese lenders tend to withdraw from cooperating with foreign fund managers due to their small size, limited pool of 200 investors, absence of long track record, and low market recognition. Thus, one should weigh the advantages of WFOE’s independence in decision making against the loss of local expertise and a streamlined local network.
Moreover, a conversion of a minority stake into a majority may become a difficult task to exercise as the local partners in joint-ventures often possess substantial bargaining capacity. The Chinese firms in mutual management companies are responsible for such key functions as managing the local distribution network and operational infrastructure, provision of brand recognition, and give access to a strong customer base.
Therefore, a decision to form a WFOE instead of participating in a joint-venture with a Chinese local partner implies that the foreign investor will not be able to enjoy the aforementioned benefits. In fact, FSA reports that the WFOE managers deem the distribution as one of their principal weaknesses that is difficult to handle. In addition, Caixin Global claims that Chinese lenders tend to withdraw from cooperating with foreign fund managers due to their small size, limited pool of 200 investors, absence of long track record, and low market recognition. Thus, one should weigh the advantages of WFOE’s independence in decision making against the loss of local expertise and a streamlined local network.
As a consequence, entering the PFM market for foreign firms is a strenuous task as they are bound to face severe competition. The difficulty of entrance is translated to a corresponding meager number of foreign players in the Chinese PFM market. Currently, there are more than 24,000 of fund management companies in China, which operate approximately 75,000 products. Of these 24,000, only 18 are foreign PFMs. But, the PFM program is only three years old, and with the new string of reforms, we can reasonably expect more firms willing to enter the industry.
To sum up, the CSRC is moving in the right direction of liberalizing the market to facilitate the entrance of foreign management firms. However, China’s asset management industry is unique and requires different modes of operation that foreign players still ought to learn. But the market potential is tremendous, and within the next couple of years, we will witness a race among global giants to build a foothold in China.
Sultan Massalov
To sum up, the CSRC is moving in the right direction of liberalizing the market to facilitate the entrance of foreign management firms. However, China’s asset management industry is unique and requires different modes of operation that foreign players still ought to learn. But the market potential is tremendous, and within the next couple of years, we will witness a race among global giants to build a foothold in China.
Sultan Massalov