Research

Domestic institutional investors in Mainland China comprise mainly securities investment funds and privately-offered funds, securities companies and insurance companies. The trust and investment companies and the National Social Security Fund also have a role. Because of the limitations of the Mainland stock market, there is increasing demand from these institutions for overseas investment.

In December 2002, Mainland China introduced the Qualified Foreign Institutional Investor (QFII) scheme which allows for the first time the entry of foreign investors into the domestic A-share market. The first QFII investment took place in July 2003. With the QFII scheme in operation, there is an increasing discussion of a corresponding mechanism for overseas investment by domestic investors ¾ a Qualified Domestic Institutional Investor (QDII) scheme. It is believed that this could help utilise China’s large foreign exchange reserves and domestic foreign exchange savings, thereby helping to maintain a better balance on the capital account.

Overseas investment by Mainland domestic investors, whether by way of a QDII scheme or not, will impact the Hong Kong securities market. It is against this background that the present examination of institutional investors in Mainland China is conducted. This article presents the framework of the institutional investor base in Mainland China, the relative degree of participation of the various investor types in the Mainland securities market, and a brief description of each major type of Mainland institutional investor.

MAINLAND CHINA SECURITIES MARKET INVESTOR FRAMEWORK

Figure 1 presents the investor framework in Mainland China securities market.

The Mainland institutional investor base is composed of the ultimate institutional investors and various types of institutional investment intermediaries. Investment intermediaries include fund management companies and their securities investment funds (SIF), securities companies, insurance companies, trust and investment companies, privately-offered funds operated by various financial and non-financial institutions, financial leasing companies and enterprise finance companies. Investment monies from individuals and institutions are channeled individually through these intermediaries into the securities market or collectively via social security funds and enterprise pension funds and possibly other social funds.

Apart from the collective channels provided by the intermediaries, the major collective institutional fund source is the National Social Security Fund (NSSF), followed by enterprise pension funds. These, together with the local social security funds in different provinces and municipal cities, are the core part of the social security system. The NSSF, the investment activities of which are governed by special rules, is allowed to invest in the securities market. The enterprise pension funds operate in a more or less commercial way and no regulations have been imposed to restrict their investment in the securities market. However, local social security funds are less organised and are allowed to invest only in bank deposits and government bonds.

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Figure 1. The investor framework in Mainland China securities market

Individuals, corporations (including state-owned and privately owned), government units and social institutions contribute to the social security funds and enterprise pension funds which in turn invest in stocks and/or government bonds through the investment intermediaries.

Institutions participating directly or indirectly in the Mainland securities market come from the three financial market sectors ¾ banking, insurance and securities. Under the current policy of “separate business, separate regulation”, these institutions are regulated by different regulators. Trust and investment companies, finance companies, financial leasing companies and commercial banks (which act as custodians for securities investment) are regulated by the China Banking Regulatory Commission (CBRC); insurance companies are regulated by the China Insurance Regulatory Commission (CIRC); and the securities companies and fund management companies are regulated by the China Securities Regulatory Commission (CSRC). This policy and regulatory framework impedes the efficiency of the financial market in resource reallocation since efficient fund flows across market segments are restricted. Therefore, there are calls for policy relaxation to allow for financial conglomerates participating in all three market segments. In practice, such conglomerates do exist in the form of separate entities held by a single holding company. As a compromise in the transition stage, there has been a proposal for “consolidated business, separate regulation”. The Mainland authorities accept that financial conglomerates are the development direction.

MARKET SHARE BY INVESTOR TYPE

According to latest unofficial estimates ¹, the aggregate investment value of the various institutional funds constitute roughly one-third of the market value of tradable stocks and government bonds on the Shanghai and Shenzhen stock exchanges. Figure 2 shows the estimated market share by type of institutional funds.

Figure 2. Estimated investment in value terms by investor type in stocks and government bonds listed in Shanghai and Shenzhen

SIFs managed by authorised fund management companies are regarded as the most regularised institutional investment in the Mainland securities market. They have the biggest market share apart from the more or less unregulated privately-offered funds. The SIF market is the focus of Mainland authorities for the development of the institutional investor base.

The investment management business of securities companies is regarded as the next most regularised institutional investment activity, i.e. after the SIFs. Taking also into account their proprietary trading, securities companies constitute another major type of institutional investor equal in importance to the SIFs.

Insurance companies are still not allowed to enter the securities market directly but only indirectly through the SIFs. About 28 per cent of SIFs in value terms is held by insurance companies, that is, about 3 per cent of the total market is held indirectly by insurance companies. Although direct participation is still restricted, because of the fast growth of the Mainland insurance industry, insurance companies offer a large future potential source of institutional funds for the Mainland securities market. It is understood that the Mainland authorities are considering allowing direct participation of insurance funds in the market.

Trust and investment companies offer a wide variety of trust funds; funds investing in securities constitute only a small proportion of these. The NSSF and QFII entered the market only in 2003. The degree of participation is still small.

There are other types of investment intermediary ¾ financial leasing companies and enterprise finance companies ¾ but these have limited participation in the securities market. It is understood that instead they are relatively more active in the futures market.

The following sections describe the major Mainland institutional investor types in turn.

Securities investment funds, or SIFs

The Mainland SIF market has a development history of some 12 years. The first SIF was issued in 1991 before the promulgation of any formal regulations. Since the first set of rules on SIFs issued in November 1997², the market has been developing in a more regulated manner. Open-end funds were introduced in 2001 upon the issuance of the related rules in October 2000.³ Before that, only closed-end funds were issued.

As at October 2003, there were 54 closed-end funds and 50 open-end funds. All the closed-end funds are listed on the Shanghai or Shenzhen stock exchanges while the open-end funds are not listed. In terms of asset value, open-end funds have a bigger share (53 per cent, Figure 3). Of the total assets of the publicly offered SIFs, about 28 per cent was held by insurance companies.

Figure 3. Asset value of SIFs by type (September 2003)

On 28 October 2003, Mainland China’s Securities Investment Fund Law (the SIF Law) was promulgated; this will be effective on 1 June 2004. The SIF Law lays down the regulatory principles and operational framework for SIFs. It covers SIFs that are offered domestically and publicly in units, managed by a fund manager, with custody service provided by a fund custodian, in the form of an asset portfolio, engaging in securities investment activities for the interests of the fund unit holders. The SIF Law mainly covers the closed-end funds and open-end funds while other forms of SIF are subject to separate regulations issued by the State Council.

The SIF Law stipulates that the investment scope of SIF assets includes listed stocks and debt securities and other securities stipulated by the securities regulator (i.e. the CSRC); and that the asset allocation of SIF portfolios should follow the requirements of the SIF Law and of the securities regulator. As understood, pre-existing regulations on SIFs that govern the detailed operation of SIFs still apply until they are superceded by implementation rules and measures pursuant to the SIF Law. According to the prevailing regulations, at least 80 per cent of a SIF’s total assets must be invested in stocks and bonds, and at least 20 per cent in government bonds.

Prior to 2002, all SIFs were stock funds (although they complied with the requirement to invest a minimum of 20 per cent of their assets in government bonds). In the recent two years, more variety of SIFs were introduced, e.g. bond funds, index funds, guaranteed funds and balanced funds. The CSRC recently disclosed that new product development is one major development direction for the SIFs.⁴

Following Mainland China’s accession to the World Trade Organisation (WTO) in December 2001, foreign participation in the fund management industry is allowed.⁵ Since then, at least eight Sino-foreign joint venture fund management companies have been established, with 14 new funds issued, including new fund types like bond funds, growth funds and balanced funds. In addition to promoting product development, foreign participation also brings in overseas expertise in risk management and internal control.

The development of the SIF market nonetheless faces with a number of barriers and policy obstacles, as described below.

(1) The uncertain future of closed-end funds - As market focus has shifted to open-end funds since 2001, the future of closed-end funds has become uncertain. No more new closed-end funds were issued in 2003 and the turnover shrank significantly.⁶ Partly because much of the ownership of the closed-end funds is concentrated in the insurance companies, liquidity is relatively low so that most of these funds are traded at a large discount to their net asset value. In developing the SIF market, the possibility of converting closed-end funds to open-end funds was raised. However, this aroused controversy since large-scale redemption is expected upon any such conversion due to the deep price discount. That would induce market turbulence which the authorities would not like to see.

(2) The resolution for privately-offered funds - This is the most problematic segment of the Mainland fund market (see the next section). The sheer size of this unregulated market makes it difficult for the Mainland authorities to deal with. The newly released SIF Law has not addressed the issue but has just provided a provision for separate regulations to be formulated. This large unregulated market segment poses a potentially high risk to the market.

(3) The lack of investment tools for portfolio management - The Mainland securities market lacks risk management tools such as short selling and derivatives for hedging and other portfolio management techniques. Unlike counterparts in overseas mature markets where portfolio diversification can reduce the impact of the market’s systemic risk, Mainland SIFs are exposed universally to the Mainland stock market’s high systemic risk (market movements are often driven by policy changes). Further, investment is confined to the domestic market where there are limited quality listed stocks. As a result, market people have been calling for SIFs to be allowed to invest in overseas markets.

(4) The investment culture of individuals - Mainland individual investors have only superficial knowledge about the concept of professional fund management, though the situation has been improving. Most individual investors still prefer to self-manage their investment. Even when they trade listed funds on the exchanges, their trading strategies are very much like speculating in listed stocks. This would be a barrier for the fund industry to expand widely and deeply into the retail investor population. For this reason, asset management for individual investors is one development strategy now being pursued by the fund management companies and is being considered by the Mainland authorities. It is hoped that through promoting this service, the investment culture of individuals could be changed, thereby opening up a major new business stream for the fund industry.

(5) Corporate governance of fund management companies - In Mainland China, fund unit holders have little participation in the management of the SIFs. The major shareholders of fund management companies in Mainland China are securities companies and trust and investment companies. In managing SIFs, there may be conflicts of interest such that the interest of the majority shareholder of the SIF manager overrides that of fund unit holders. Accordingly, the SIF Law attempts to provide better protection of the rights of fund unit holders. Under the SIF Law, SIF unit holders holding in aggregate 10 per cent or more of the SIF units may request a SIF unit holders’ meeting, which may be held upon attendance by unit holders holding more than 50 per cent of the units. However, the effectiveness of this in resolving the problem of insider control remains to be seen.

Privately-offered funds, or PVFs

As their name suggests, PVFs are funds offered privately to investors, whether institutional or individuals, without any public disclosure of information on the fund itself or the fund manager. Much of these PVFs’ investment has been in the domestic stock market. In fact, securities companies were the first to offer some kind of PVF as an investment service to their clients. PVFs were introduced in the early 1990s. In the absence of relevant rules and regulations, they expanded on the back of the flourishing stock market in the late 1990s. Even now, the current rules and regulations on securities investment funds govern only the publicly-offered SIF.

Institutions that offer PVFs include investment advisors and consultants, finance consultants, investment management companies, financial management companies and the so-called “workshops” which are formed by individuals or institutions. There are no official or unofficial statistics on the size of the PVFs. One estimate of the total value of the PVFs from a study done in 2002⁷ was about RMB800-900 billion. After a two-year bearish market, many PVFs with unregularised operation have been closed down. One estimate is that the size has shrunk to about RMB200 billion.

It is believed that because of their partially “underground” nature, many PVF have already been investing in overseas markets through underground channels. If regulations are introduced to supervise PVFs, such informal overseas participation might be restricted.

Securities companies

Securities companies participate in the securities market as institutional investors in two ways: (1) proprietary trading and (2) investment management for clients.

Securities companies in Mainland China are classified into two types: consolidated type and brokerage type. As in December 2003, there are 136 authorised securities companies in Mainland China, of which 25 are consolidated type.⁸ Only the consolidated-type securities companies are allowed to conduct proprietary trading in securities and investment management for clients. While proprietary investment of securities companies remains small in proportion, the investment management business of securities companies is of a bigger size and has large growth potential.

The investment management business of securities companies was introduced in late 1996. It started in an exploratory manner in the light of tightened regulation over the proprietary trading of securities companies. As in the case of PVFs, the business operated initially in the absence of relevant rules and regulations. Against this background, the investment management business of securities companies expanded rapidly from the second half of 1999 when the Mainland stock market entered a two-year-long bullish period.

Investment returns in the bullish stock market were much more attractive to business corporations than income from normal corporate business and low-interest-bearing bank deposits and bond holdings. Some incomplete statistics reveal that in 2000, 50 to 100 listed companies concluded investment management agreements with securities companies; in the first half of 2001, at least 26 listed companies signed about 50 investment management agreements, involving an asset value of RMB4.3 billion.⁹

In the light of their high income potential, securities companies began to offer guarantees on the principal and a guaranteed return and many asked for a share of the investment return. The over-expansion of the business exposed securities companies to high operating risk. The market downturn of the past two years caused difficulties for many securities companies as many of them could not honour their return guarantees. It is understood that many are still operating at a loss. In November 2001, the CSRC released a notification to govern the sector.¹⁰ Securities companies were given two years to rectify their existing investment management business. Current estimates are that the securities companies’ investment management business has a size of about RMB80-100 billion. The estimate includes “hidden” accounts maintained by securities companies which have not been reported to the regulator as they have not been properly rectified under the prevailing rules.

Despite the loss-making experience in recent years, securities companies are still actively developing their investment management business as a major growth area. Recent initiatives included collective investment plans offered to retail investors, some in cooperation with commercial banks to take advantage of the latter’s wide distribution network. However, these collective investment plans were subsequently banned by the CSRC in April 2003. No new plans can now be offered before the relevant rules are released. However, plans which are already in operation may continue. Currently, the authorised investment management business of securities companies is confined to non-collective investment management on individual account basis. After consultation with the industry, a comprehensive set of rules on the investment management business of securities companies were recently released on 18 December 2003, to be effective on 1 February 2004. Under the new rules, “collective asset management plans” will be allowed.

In addition to collective investment plans ¾ which securities companies see as having high business potential ¾ investment management on an individual account basis is another new development direction. Up to the present, the clients for investment management have mostly been large state-owned enterprises. Their investments are usually not long-term and investment requirements in general do not comply with the regulations, e.g. requesting a guaranteed return. As a strategic move, securities companies started to shift their target clients to enterprise pension funds. The enterprise pension market is currently dominated by insurance companies. Fund management companies are also lobbying for participation in asset management business for individual clients. (Currently, the only authorised asset management business of fund management companies is for the NSSF.) Increasing competition in this market segment is expected.

Insurance companies

Starting from late 1999, insurance companies have been allowed to invest in the Mainland stock market indirectly through SIF. Prior to that, they were only allowed to invest in government bonds and bank deposits.

Because of the fast development of the Mainland economy, there is an increasing demand for insurance by various economic sectors. Accumulating personal wealth also spurs individuals to place spare money into insurance schemes for insurance or investment purposes. As a result, the Mainland insurance industry has grown rapidly (see Figure 4). By the end of September 2003, the total asset value of the insurance companies was RMB833 billion, equivalent to 7.9 per cent of Mainland China’s 2002 gross domestic product.

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Figure 4. Total asset value of insurance companies and annual growth rate Source: China Insurance Regulatory Commission website

Note: For 2003, the annual growth rate is an annualised figure based on the first nine months’ growth rate in 2003.

According to the current regulations¹¹, the investment of insurance funds is confined to the domestic market and is limited to the following:

• Bank deposits;
• Government bonds;
• Financial bonds;
• Corporate bonds with a rating of above AA grade from a recognised Mainland China rating agency;
• Repurchases of government bonds and financial bonds in the interbank market upon authorisation by the central bank, the People’s Bank of China (PBOC) as a member of the interbank market;
• SIFs;Other means of fund utilisation as authorised by the State Council.

In addition, investment in specific instruments by insurance companies is also subject to specific upper limits imposed by the CIRC. Investment in a single SIF should not exceed 3 per cent of the insurance company’s total asset value on a cost basis, and aggregate investment in SIFs should not exceed 15 per cent.

As at the end of September 2003, insurance companies had 89 per cent of their total assets placed in investments. Of this, 52 per cent (RMB383 billion) was bank deposits and 48 per cent (RMB355 billion) was invested in bonds and other permitted investments. This investment composition appears to be conservative in comparison with the practice in Europe and North America where bonds and stocks account for about two-thirds of the total investment of insurance companies.¹² However, it should be borne in mind that the investment in SIFs by Mainland insurance companies is subject to an upper limit of 15 per cent. The investment in SIFs by insurance companies was RMB46 billion as at the end of September 2003, accounting for 13 per cent of the latter’s overall investment portfolio (excluding bank deposits). This has grown from 2 per cent in 1999. (Figure 5)

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Nevertheless, the room for industry growth is very large as the penetration rate¹³ is still very low ? 3 per cent in 2002, compared with 9 per cent in the US and 6 per cent in Hong Kong in 2001, and the insurance premium per capita¹⁴ is also very low ? RMB238 in 2002, compared with US$3,266 in the US and US$1,545 in Hong Kong in 2001¹⁵. With the rapid expansion of the industry, the growth in insurance investment in the stock market is expected to be rapid even with the fixed percentage investment limit.

As a result of rapid asset expansion and for the sake of healthy industry development, there is an increasing demand for expanded investment channels for insurance assets. Currently, returns on bank deposits and government bond holdings are low due to low interest rates. The returns on SIF investment are not very promising either due to the bearish stock market in the recent years. Investment in SIFs is also subject to the risk of poor corporate governance on the part of fund management companies. It should also be borne in mind that insurance companies themselves often provide a guaranteed return on their policies and these guaranteed returns are much higher than the prevailing market returns on their investments. As a result, there is a serious imbalance between policy liabilities and (low) investment returns; many insurance companies have been operating at a loss. There have been calls to allow insurance companies to invest directly in the stock market and manage their own investment portfolio directly instead of through SIFs; and calls for opening outward investment channels to overseas stock markets in order to diversify risk and increase return.

Trust and investment companies, or TICs

TICs are a type of financial institution now under the jurisdiction of the CBRC (formerly under the PBOC). Before the turn of the century, the TIC sector went through a chaotic period because of the lack of proper rules and regulations. There was over-expansion in the number of companies and a proliferation of investment into various kinds of assets, including the property and equity markets. After the Asian financial crisis in the late 1990s, a number of TICs began defaulting on loans and some became insolvent.

In 1999, the TIC sector entered a rectification process under the direction of the Central Government. Mainland China’s Trust Law was introduced in 2001 to provide basic regulation for the industry. The PBOC subsequently issued administrative measures¹⁶ in 2001 and 2002 to govern the establishment and operation and investment of TICs. The number of authorised TICs was reduced to 60. According to the regulations, TICs may manage capital trusts on an individual contract basis or on a collective basis with multiple contracts. For the collective management of contracts, the number of contracts involved should not be more than 200 and each contract should not be less than RMB50,000.

Since the rules allowing collective capital trusts became effective, TICs began to actively introduce this kind of product. During the first three quarters of 2003, 139 investment trust plans were issued involving RMB10.1 billion of funds. For the 51 such products issued in the third quarter of 2003, 28 per cent were invested in the securities market. (Figure 6)

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Figure 6. Allocation of funds by sector for collective capital trust products issued in third quarter of 2003 (51 products, total funds = RMB 3.6 billion)

The investment scope of the TICs is very extensive. In accordance with the regulations, trust business may be in tangible and intangible property and rights, fixed or liquid assets or other assets. Taking into account collective capital trusts and other trust types, the proportion of total TIC assets investing in the securities market would be relatively low, albeit no statistics are available. Nevertheless, the investment activities of the TICs are subject to fewer restrictions than the investment management business of the securities companies and SIFs. TICs are therefore freer to introduce more variety of collective capital trust products to cater for different customer needs. The growth potential in this area should not be under-estimated.

NATIONAL SOCIAL SECURITY FUND, or NSSF

The NSSF was established in 2000 as a complementary vehicle to support the social security system in Mainland China. The sources of funds for the NSSF are mainly fiscal subsidies from the Central Government and proceeds from the reduction of state-owned shareholdings at initial public offers (IPOs) of enterprises seeking an overseas listing and their subsequent share issuance.¹⁷

The social security system in Mainland China is mainly composed of a number of social insurance funds ¾ pension funds, medical insurance funds, unemployment insurance funds, occupational injury insurance funds, child birth insurance funds and rural pension funds. These funds are operated at the local (provincial) government level. The current status is the result of a radical reform process that has been going on since the 1990s. The post-reform model is basically established by now. Under the new model, enterprises are relieved of the responsibility of directly operating and managing the social insurance funds; these functions are now centrally administered by the Ministry of Labour and Social Security (MOLSS) and its agency institutions. The policy approach emphasises a three-party contribution model ¾ the State, the enterprises and the individuals. However, in many less-developed provinces, cities or xians (counties), the set-up of the social insurance funds is only very basic. In the meantime, the aging population and rising unemployment as a result of state-owned enterprise reform have increased the burden of pension, medical and unemployment insurance. In the light of this, there is an urgent need for Central Government support. The NSSF is therefore established to cover unfulfilled insurance obligations borne by the local governments.

The administration and investment of the NSSF are independent of the local social security funds. The latter are administered by the local governments and may invest only in bank deposits and government bonds. Little or no participation in the securities market is expected from them.

The operation of the NSSF is overseen by the NSSF Council established under the State Council. According to relevant rules¹⁸, the NSSF may invest in bank deposits, government bonds and other financial instruments with high liquidity, including listed and tradable SIFs, stocks, corporate bonds and financial bonds with investment rating. Except for bank deposits and government bonds subscribed in the primary market, investments have to be entrusted to appointed NSSF investment managers and custodians. Currently, six fund management companies are appointed to be investment managers for the NSSF, managing some 14 NSSF portfolios (eight in stocks and six in government bonds). The investment activities of the NSSF are subject to tight restrictions, including the following (on cost basis):

• At least 50 per cent of assets in bank deposits and government bonds with bank deposits not less than 10 per cent;
• Not more than 10 per cent in corporate bonds and financial bonds;
• Not more than 40 per cent in SIFs and stocks.

As at the end of 2002, the value of the NSSF was RMB124 billion, an increase of 54 per cent from 2001. It had grown to RMB133 billion by November 2003.¹⁹ Notwithstanding the (generous) upper investment limit of 40 per cent in SIFs and stocks, less than 5 per cent of NSSF assets are actually invested in the stock market.²⁰ The total size of the NSSF is expected to increase relatively rapidly because (1) the Central Government aims to raise the proportion of fiscal expenditure on social security expenses to 15 per cent²¹; and (2) the expected large overseas IPOs of a number of state-owned enterprises in the coming years will make a substantial contribution to the NSSF. Therefore, the potential of the NSSF to become a major institutional investor in the securities market is high. Moreover, it is reported that the Mainland authorities are considering a proposal to allow the NSSF funds contributed from the overseas IPOs of state-owned enterprises to remain overseas for investment in overseas markets.

CONCLUSION

Domestic institutional investors in Mainland China face a lack of investment channels and lack of portfolio management tools. They are eager to seek ways to increase profit opportunities and diversify risk. Investment in overseas securities market is one possible way to achieve both goals. Among the various institutional investor types, SIFs are the most regularised and are the major focus of Mainland authorities for developing the domestic institutional investor base. Nevertheless, the possibility of other major types of institutional investors being allowed to invest overseas should not be under-estimated.

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