The pace of change in the financial markets of the People's Republic of China (PRC) continues unabated. Apart from the presence that foreign banking and securities institutions have established on the mainland in the last year, many financial institutions show considerable interest in opportunities to attract investment from mainland investors. To capitalise on these opportunities, a gradual process of liberalisation has been underway as the PRC has implemented changes to facilitate outbound investment by its nationals.

The PRC-qualified domestic institutional investor scheme had a slow start since its inception in 2006, but recent changes and relaxations to the scheme may change this, as they facilitate greater investment in offshore funds and other investments.

The potential of the PRC's outward investment potential is considerable: in June 2007 the National Bureau of Statistics in China announced the country's foreign exchange reserves to have reached $1.33trn (£663bn); with a trade surplus of an impressive $112.5bn (£566bn) for the first six months of the year.

More choice for PRC investors in offshore markets

Discussions concerning a relaxation of the currency convertibility and capital accounts restrictions date back to 2001 when the PRC became a member of the World Trade Organisation. In the years following 2001, the pressure on the PRC to act gathered momentum amid rising foreign reserves and international concerns, particularly in the US , as to the comparative value of the renminbi.

In April 2006, the People's Bank of China, China's central bank, introduced the long-awaited Qualified Domestic Institutional Investor (QDII) scheme. In contrast to the established Qualified Foreign Institutional Investor (QFII) scheme which allowed direct foreign investment in PRC domestic securities, the QDII scheme allowed PRC nationals to invest in offshore markets (through qualified domestic institutional investors) within prescribed limits. The PRC authorities intended that QDII and QFII together would facilitate capital flows between the PRC domestic and offshore markets.

However, in the first year of its operation, the QDII scheme proved relatively unpopular with PRC investors due to the low returns from the mostly fixed-income QDII products compared to investing in PRC equities.

With a view to increasing the attractiveness of the QDII scheme to PRC investors, the PRC authorities widened the scope of the scheme in May 2007 by giving qualified commercial banks more choices to invest in offshore markets. Since then, restrictions have been further relaxed for qualified securities institutions and insurance companies.

Regulation maze

The QDII scheme enables PRC nationals to invest in overseas markets through qualified domestic institutional investors (such as commercial banks, securities institutions (which include fund management companies and securities companies) and insurance companies), within the limits of the scheme.

In addition to the QDII scheme, a similar scheme is operated by the National Social Security Funds (NSS Funds). Both the QDII and the NSS Funds are subject to regulatory control by a number of governmental regulators, although rules made by the various bodies may vary in terms of permitted investment activities and financial products, and there is no 'standard approach' taken by all regulators.

Relaxation for commercial banks

As mentioned, initial take-up of QDII products by PRC investors was limited. From commencement to May 2007 it is believed that only 3% of the $15bn (£7.5bn) worth of quotas had been used – despite the increase of foreign currency conversion quota per PRC individual announced by the State Administration of Foreign Exchange (SAFE) in January 2007, from $20,000 (£9,975) to $50,000 (£24,940) per annum.

Accordingly, the China Banking Regulatory Commission (CBRC) issued the Notice of the Adjustments to the Offshore Investment Scope of Overseas Wealth Management Business of Commercial Banks on Behalf of Their Clients (Notice), to widen the scope of the QDII scheme.

The notice has removed the prohibition on investments in offshore equities by qualified commercial banks and allows them to invest up to 50% of the total net asset value of QDII funds in offshore equity markets. However, a number of restrictions continue to apply to relevant fund vehicles through which overseas investments may be made, and hedge funds are included in the list of products in which investments may not be made.

The CBRC is currently drawing up a regulatory framework for the PRC's private banking industry and it is believed that such regulatory framework will set out mandatory qualifications for wealth managers and include clear risk management requirements to protect PRC investors. However, this is not expected to be released until at least the end of 2007.

Rules for Securities institutions

Following on from the relaxation of the QDII scheme rules for qualified commercial banks in May 2007, the Tentative Procedures for the Administration of Overseas Securities Investments by Qualified Domestic Institutional Investors (Tentative Procedures) and the Circular Concerning the Implementation of the Tentative Procedures (Implementing Circular) were issued by the China Securities Regulatory Commission (CSRC) on 20 June, 2007.

The Tentative Procedures elaborate on the qualifying criteria for securities institutions seeking QDII qualification. They also specify additional qualification criteria applicable to fund management companies and securities companies.

The Implementing Circular permits qualified securities institutions to invest in publicly-raised offshore mutual funds that have been registered with their national securities regulatory authority, provided the regulatory authority has signed a memorandum of understanding (MOU) for co-operative regulation with the CSRC. By the end of May 2007, 33 regulatory authorities had signed an MOU with the CSRC.

However, despite this the Implementing Circular currently has limited impact as neither the Cayman Islands nor the British Virgin Islands, popular jurisdictions for offshore funds, have signed an MOU with the CSRC. Also, funds that are offered by private placement are not regarded as 'publicly raised offshore mutual funds'.

The Implementing Circular does not clarify whether the funds in which qualified securities institutions may invest need to be open-ended or closed-end. However it is understood that the CSRC makes no distinction between open-ended and closed-ended funds for the purpose of the Tentative Procedures and the Implementing Circular and, in consequence, it appears that qualified securities institutions can invest in both closed-end and open-ended funds.

By contrast, the Implementing Circular does not specifically prohibit qualified securities institutions from investing in hedge funds, but it is understood that the CSRC does not consider that investments in hedge funds by qualified securities institutions are permitted.

In addition to the above relaxations to the QDII scheme rules for qualified commercial banks and qualified securities institutions, the CIRC issued the Interim Administrative Measures for Overseas Investment of Insurance Funds in July 2007. These expand the range of products into which qualified insurance companies may invest to include shares and options (in addition to fixed income and money market products). Implementing rules, which will clarify the scope of the changes are, as yet, unpublished.

Impact on international financial markets

The recent widening of the scope of the QDII scheme in relation to qualified commercial banks, qualified securities institutions and qualified insurance companies illustrates the PRC Government's desire to ensure that the QDII scheme is successful.

This increasing liberalisation of the PRC's capital markets represents a further step in the integration of the PRC into the global financial system, and the impact of the relaxation of the QDII scheme rules is expected to be significant.

Changes in the laws and regulations for Chinese outbound investments are expected to continue in the coming months, and more financial products may be added to the permissive list for qualified PRC investors to make overseas investment through PRC-qualified institutions.

Indeed, the 'stop press' nature of the current pace of change in this area is further illustrated by an announcement made by SAFE as this article goes to print. On 20 August, SAFE announced a pilot scheme which would allow PRC individuals to open foreign exchange accounts at the Bank of China's Tianjin branch and trade unlimited stocks on the Hong Kong Stock Exchange. Bank of China branches throughout the PRC will act as agents for the Tianjin branch. As yet there is no set date on when the pilot scheme will start. Time will tell what impact the pilot scheme will have on the QDII scheme.

Jane Newman is resident partner at Simmons & Simmons in Shanghai.