CHINA'S A-SHARE market - the part of the People's Republic's equity market that until recently only domestic investors could access - is distinctly investor-unfriendly.
It has after all been well headlined that some of China's less scrupulous brokerages have been involved in price ramping, money laundering and other irregularities on the A-share market. Few of the 1,200 companies listed have ever heard of the term corporate governance. In addition the $500 billion market has a P/E ratio of around 40, making it the world's most expensive. It manages, though, to combine this with being one of the world's worst performers.
It would seem a wise plan to keep your money as far away as possible from the A-share market. Yet when the Chinese authorities announced at the end of 2002 that it would be opened to foreigners under a qualified foreign institutional investor (QFII) scheme, global investment banks raced to be the first to jump in. Citigroup, Goldman Sachs, Morgan Stanley, Nomura and UBS were all in the leading pack. And in the second week of July, UBS took the plunge and became the first foreign institution to invest directly in this opaque world.
The Chinese view opening up the A-share market as critical to reform. As more money from abroad is allowed into it, the corporate governance, transparency and strategies of Chinese companies will be hauled up by the bootstraps. In addition the money will bolster the market. Taiwan, which set up a similar scheme in 1991, has, according to UBS's managing director and global head of Asian distribution, John Holland, experienced net inflows of foreign capital nearly every month. And now 12 years on, $35 billion of foreign capital is invested in the market.
The QFII scheme is, however, tightly controlled. Foreign investors do not have unlimited freedom to go into the market and start throwing any amount of money they wish at the stocks available.
When seeking the QFII licence, each bank had to apply for a quota on how much it could invest. The minimum was $50 million and the maximum $400 million. Both UBS and Morgan Stanley pushed toward the high end and were rewarded with a $300 million ceiling. Goldman Sachs, however, was more cautious and decided that in the short term $50 million would be enough.
In addition to the money limits, investors cannot withdraw their cash as fast as they put it in. Closed-end China funds have to keep their money in the country for three years after their initial investment. And other qualified institutional investors cannot withdraw funds for a year after they first invest.
Restrictions on removing capital bar most fund managers from going anywhere near the scheme. And though many are interested in committing some funds, most are sitting on the sidelines.
To open the system wide immediately would send it into shock. As UBS's Holland says: "To say that the scheme is too restrictive or the pace at which it is being implemented too slow is missing the point. The regulators in China are assessing the structure and adjusting it to accommodate how international investors do business. They have opened the door. Rather than standing back and complaining that the point of entry is too narrow, let's lean on the door and help open it wider."
Why are the investment banks so keen to break into such a questionable market now? When answering this question, bankers often prefer to remain anonymous in case the Chinese authorities suddenly realize that their primary objective isn't, in fact, to help China.
Getting in on something big
One banker leading the QFII charge for his institution is frank when he says: "It's not so much about what we can get out of it now, it's about the promise of what we can get in the future."
Holland agrees when he says: "It's an enormous marketplace that people have to know about, whether they think there is value today or not. But it's clear that clients want to know and need to know more."
A head of equities at another bank puts a slightly different spin on his reasons. "China is like a disruptive technology. It's genuinely breaking the mould of how activity is done in the region. You don't quite know what bit of business is going to come in from where, but that, quite frankly, is not the game. You don't throw money at it willy-nilly but you do realize that something big is happening. And you want to be part of it."
Raising interest and, more important, funds, from end clients has not been an easy process for the investment banks. After all, A-shares are not a benchmark market so why shouldn't fund managers just ignore it?
Nicole Yuen, executive director and head of equity corporate finance at UBS, says that's the wrong attitude: "We are looking at an emerging market that is big and investors can't ignore - in Asia and in the context of the world."
Another problem to overcome and explain to investing clients is how investment banks will approach stock selection. With an overall P/E ratio of over 40, the valuations are, to put it mildly, a little rich. Add to this the fact that not very much is known about the majority of Chinese companies, and placing money there does not seem like an attractive proposition.
Yuen acknowledges that the market's P/E ratio is expensive if it is viewed from a macro point of view. But she says: "The A-share market is a giant mammal. Some companies on it are making losses. So if you divide the number of earnings by the market cap then the P/E ratio will automatically be high. It's not a relevant number and shouldn't be focused on. You should be focused on the P/E ratio of the companies that you are interested in."
After extensive marketing across Asia, Europe and the US hammering this point home, UBS was able to convince some clients to part with their money. Although Yuen refuses to disclose exactly how much, she does say that it is significantly more than $50 million. And of UBS's $300 million limit, she says: "We are making inroads into that number."