Recruiting in China

BEIJING -- When China announced in April it was easing its strict foreign-exchange rules to allow individuals and companies to invest offshore, markets in Hong Kong and other parts of Asia sensed quick profits.

Reality is starting to disappoint. In the past week, Industrial & Commercial Bank of China and Bank of China launched the first products through which Chinese savers will be allowed to access global markets. But now analysts don't expect more than a trickle of money from China anytime soon. That is bad news for any bulls anticipating a near-term boost to Chinese stocks listed in Hong Kong, which would be the natural first destination for Chinese-mainland funds chasing higher returns.

April's announcement that Chinese authorities had approved outbound fund flows under the long-awaited Qualified Domestic Institutional Investment, or QDII, system looked like an obvious boost for regional markets, particularly Hong Kong. China has some $4 trillion in savings, about half owned by individuals and half by companies, and most of it sits idly in banks collecting paltry interest. Companies like China Eastern Airlines and Sinopec Yizheng Chemical Fibre seemed like they could be the biggest beneficiaries, since their Hong Kong shares trade more cheaply than a separate class of their shares listed in Shanghai -- making the Hong Kong shares a natural arbitrage play for mainland investors.

In the longer term, that pattern may yet play out. But the QDII system is both cumbersome and costly -- making any quick expansion of the program unlikely.

The QDII system offers foreign-exchange quotas to approved banks, insurance companies and asset-management firms for overseas investment. But to protect novice investors, banks and insurers that control the bulk of China's savings will only be allowed to offer customers products that invest in fixed-interest instruments, like bonds, instead of more volatile equities. Asset-management companies will be free to offer equity funds -- but to selected clients, not the general public.

Heavy-handed regulation is likely to limit the Chinese public's interest in QDII investments, analysts say. The impact on global bond and equity markets of QDII outflows will be "virtually negligible" said Hong Kong-based HSBC analyst Zhi Ming Zhang in a research report last month.

One problem for banks offering QDII products is that they must contend with requirements that they give full protection to clients against currency risks that arise when they convert savings in yuan into foreign currency. This adds to the expense of running the funds -- and limits the range of products banks can sell, since no yuan hedging tools are available to cover currency risks on products with long maturities, like 10-year U.S. Treasury bills.

The Industrial & Commercial Bank of China's first QDII product, which went on sale Monday, will invest mainly in money-market notes with a six-month maturity. It promises investors returns of 3% to 7%.

Impediments aside, the hefty size of the first QDII quota allocations surprised many analysts -- a total of $4.8 billion was divided between Industrial & Commercial Bank of China, which received $2 billion; Bank of China, with $2.5 billion; and Hong Kong-based Bank of East Asia, with $300 million.

Kinger Lau, a Hong Kong-based Goldman Sachs analyst, says he expects Beijing will expand the quotas to $10 billion this year and says that "long term, it's very positive news" for the Hong Kong stock market. Mr. Lau says an obvious QDII winner will be Hong Kong Exchanges & Clearing, the listed holding company of the Hong Kong stock and futures exchanges, which will benefit from rising turnover. Hong Kong Exchanges' shares closed trading yesterday at 50.20 Hong Kong dollars (US$6.46), up about 56% since the start of the year, although off highs in May of about HK$65.

Morgan Stanley analyst Jerry Lou argues that in time there could be upside for Hong Kong-listed firms in sectors that are under-represented on mainland bourses, such as banking, insurance and telecommunications.

There are plenty of other head winds for outbound portfolio investments from China. For a start, China's own equity markets look enticing again after a long slump. The Shanghai index is up almost 40% since the start of this year. Among the star performers: Beijing-based Citic Securities has surged 160%, and car maker Shanghai Automotive is up more than 70%.

There also are strong incentives to keep savings in yuan amid expectations that Beijing will be forced to allow faster currency appreciation to narrow its huge trade surpluses, which are causing friction with the U.S. The few Chinese companies allowed to hold foreign exchange offshore for investment have been pulling their money back home. Shanghai-based Bank of Communications has repatriated all of the proceeds of its $2.2 billion stock-market listing in Hong Kong last year.

Wang Jizhou, a professor at the Capital University of Economics & Business in Beijing, says right now "money would rather stay in China." QDII, Mr. Wang argues, "is more meaningful in political terms than in economic ones" because it signals China's willingness to start draining its vast foreign-exchange reserves. The reserves, which stand at $941 billion, draw attention to China's politically sensitive trade surpluses.