Cerulli Global Edge: RMB ETFs, progress and prospects

Cerulli Global Edge, July 2012

The internationalization of the RMB has already had a profound impact on the banking and fund management industry in a host of different areas. From trade settlement to foreign exchange, debt capital markets to cash management, banks and fund managers are positioning themselves to take advantage of one the most significant change in world currency markets so far this century. And on the asset management side, the next stage of this process will be the development of RMB ETFs outside of mainland China.

Strictly speaking, this process has already started; in February the Hang Seng RMB Gold ETF became the first exchange traded fund to be traded in RMB on the Stock Exchange of Hong Kong. Hang Seng Investment Management launched the fund, much to the delight of the exchange, which was able to boast that it now hosts listed debt securities, REITs and ETFs denominated in RMB. It was an interesting way to launch the market – not with an equity or debt underlying, but a commodity generally quoted in US dollars. Like all offshore RMB products, it was designed to give Hong Kong investors options to use the surplus RMB that many of them have accumulated through trade with the mainland.

Still, according to data from Morningstar and Lipper (see chart), that means that just one out of 43 RMB ETFs is listed outside of China; it is, to date, an overwhelmingly domestic field. The domestic funds have about RMB80 billion in assets under management between them.

Instead, with the Hang Seng gold ETF something of a one-off, the really interesting bit – expansion of RMB products outside the mainland – is still to happen. But it’s on its way. The China Securities Regulatory Commission has issued licences to four Chinese fund companies to launch RMB ETFs in Hong Kong under its R-QFII program.

First, some background. QFII, which stands for qualified foreign institutional investors, is a long-standing program allowing foreign managers to invest in mainland securities. They are allocated quota by the People’s Bank of China, often in chunks of $100 million or so, and through this quota they can invest in the mainland either for their own account, for private clients, or as a method of underpinning a fund.

R-QFII is a more recent subset of this program and applies to Chinese fund managers who have accrued large amounts of RMB outside the mainland, typically through Hong Kong subsidiary offices. R-QFII allows them to repatriate those funds back to the mainland for investment, creating new funds in the process. A first batch of R-QFII funds was not greatly successful; these funds – of which 21 were licensed, many of them very similar to one another – had to invest at least 80% of their assets in the onshore bond market, and they did not seem to capture the popular imagination. But this did not stop CSRC greatly increasing the scale of RQFII quota, from an initial RMB20 billion to RMB70 billion, in April. The second batch of funds that come from this expanded quota will be different: they will be ETFs, tracking equity indices on the mainland, and in the first instance will be limited to just four fund managers (each one obliged to follow a different index, in order to make sure the products are well differentiated from one another).

The four will be China Asset Management (Hong Kong), whose ETF will track the CSI 300 Index; Harvest Global Investments, which will track the MSCI A-shares index; E Fund Management (Hong Kong), following the CSI 100 index; and CSOP Asset Management, following the FTSE China A50 index. Each of these is expected to receive between RMB3-4 billion at first, and it is understood that all four are awaiting approval from the Hong Kong Securities and Futures Commission, after which they are expected to be listed promptly.

How significant is all this? It fits into the broader context of China’s attempts to find ways to allow offshore RMB to flow back onto the mainland. In turn, it represents a part of the gradual process towards full liberalization of the currency. From an investment perspective, it’s another useful way that Hong Kong people with RMB holdings – and there are billions of RMB held by ordinary investors and small businesses in Hong Kong – can do something with them other than buy near zero-yielding deposits or so-called dim sum bonds (offshore RMB bonds domiciled in Hong Kong). From the issuer perspective, they are a new opportunity to tap surplus assets while continuing to steal a march on foreign competitors: so far, no foreign groups (notwithstanding Deutsche’s connections with Harvest) have been allowed to launch RMB ETFs outside China.

In future, though, why wouldn’t they? Plenty of foreign managers have launched dim sum funds – although those invest in assets outside mainland China, not within – and there’s no reason we shouldn’t see, for example, RMB ETFs based on those dim sum funds. For the moment, access to onshore securities is the difficult issue, but as the asset base of RMB securities outside China grows, the need to go to the mainland for underlying investments decreases.

After all, Hong Kong Exchange is no stranger to China A-shares; as of May 2012, 24 of the 92 ETFs listed on the exchange were over mainland Chinese shares (A-shares) as an underlying asset class. The biggest, the iShares FTSE A50 Index, has net assets of HK$46.3 billion (US$6 billion) as of the end of March. But these are denominated in Hong Kong dollars, not RMB, and are synthetic, whereas the new RQFII products will be physical – an approach increasingly favoured by Hong Kong investors.

Despite some apparently slow approval processes, there’s no question Hong Kong wants securities like these. It held a detailed set of presentations in June for RQFII issuers – those known to have quota, and also those still hoping to get some – and has so far completed four market rehearsals in the last two years for exchange participants to ensure their front and back end systems and procedures can handle RMB transactions. The exchange says that over 80% of exchange participants, in terms of market share, have already traded RMB products, mostly bonds. Hong Kong knows that China, and the changes in the freedom of its currency, represent a huge opportunity for the exchange. Hong Kong is a testing ground for China’s new ideas – which is proving a lucrative role to have.

Also, as RMB increasingly circulates in other markets outside China, we could expect RMB ETFs to be launched in those locations too. London, for example, recently hosted an offshore RMB bond, and is pushing hard to become a second offshore RMB centre outside Hong Kong. Singapore, too, has a stock exchange that has embraced innovative structures in order to grow – it hosts Asia’s most sophisticated REIT market, for example, and more recently business trusts – and has been making efforts to become an offshore RMB alternative to Hong Kong too. Singapore already hosts a number of dim sum funds, both from local names like Fullerton Asset Management, and from multinationals running their funds from Singapore such as Barclays.

Alongside this is the growing global interest in ETFs globally as a convenient, cheap, passive building block to assemble portfolios. The combination of an increasingly popular structure, with a globalising currency, suggests a promising future for RMB ETFs.