Word is out that the outline of the qualified domestic institutional investor (QDII) system is finally complete. But the content of the draft is top secret, according to one overseas asset management company official, who asked to remain anonymous. "We do not have a clue about its content or launch date," he said.

One year after China opened the door to foreign institutions to trade yuan-denominated A-shares and bonds with its approval of the qualified foreign institutional investor (QFII) system, the country now seems to be ready to open another door. QDII is expected to free billions in foreign exchange funds for overseas capital markets.

The QDII, a twin scheme to QFII, will allow Chinese citizens to invest in overseas equities markets with designated foreign currencies through qualified institutional investors, such as fund management companies.

"We are actively pushing the QDII program," said Ma Delun, deputy director of the State Administration of Foreign Exchange (SAFE) at a high-profile forum in Beijing in late May. He said that the authorities had drafted a legal framework for QDII and rules of implementation to allow social security and insurance funds to invest overseas.

His words were echoed by Liu Mingkang, chairman of the China Banking Regulatory Commission (CBRC). Liu recently stated that QDII management regulations will be unveiled soon.

These periodic disclosures from officials are thought to be tactics for spurring progress in policy-making.

China is under international pressure to revalue its currency as its foreign exchange reserves swell. Forex reserves surged 40 percent year on year to reach $403.3 billion at the end of last year, according to SAFE.

In mid-May, China approved three more QFII licenses, for Merrill Lynch, Hong Kong's Hang Seng Bank and Japan's Daiwa Securities. This brings the total number of licensed QFIIs in China to 15.

The steady entry of foreign capital has added pressure for foreign exchange regulators to keep forex inflow and outflow balanced and maintain the stability of the yuan.

In anticipation of a stronger yuan, speculative funds may flow in and further increase China's forex reserves. This makes SAFE very uneasy.

That helps explain the enthusiasm of the forex authorities for introducing QDII to encourage more domestic institutions to invest overseas.

"The introduction of QDII is inevitable, because China cannot always use administrative methods to bar the flow of capital as the nation tries to integrate itself into the global economy," said Han Yi, an analyst with Centergates Securities.

The launch of QDII should guide the capital outflow into official channels, which would make it easier for the authorities to control capital outflow and fend off financial risks, Han said.

"Although the initial size of the QDII scheme will likely be small when compared with China's US$400 billion in forex reserves, it will exert downward pressure on those reserves in the long term," said Yi Xianrong, an economist with the Chinese Academy of Social Sciences' Institute of Financial Research.

The CBRC is also buoyant about QDII as it could bring more business opportunities domestic banks.

Banking authorities, for example, have put the preparation of custodial bank at the top of the agenda. CBRC Chairman Liu Mingkang said that after QDII takes off, it will need experienced banks to provide custody. Foreign banks, with more expertise in developed markets, have an advantage in this area, but their domestic counterparts that have been trying for QFII custody do not want to lag.

Hong Kong's stock market will be the testing ground for the scheme, analysts predict. The Hong Kong market has been looking forward to its initiation.

Stimulated by QDII aspirations, Hong Kong H-shares have surged 35 percent from 2,030 points at the end of April in 2003 to the present 2,700. Since talk of an imminent launch of QDII spread in the first quarter, H-shares and red chips have staged several bullish rallies, although none of them lasted for long as lack of clarity about timing weakened the elevating effect.

But this is not something that can be decided by a single department. It requires a consensus of different sectors.

Creating a QDII policy involves a chain of government departments, such as the National Development and Reform Commission (NDRC), the Ministry of Finance (MOF), the (PBOC), the China Securities Regulatory Commission (CSRC), the China Insurance Regulatory Commission (CIRC), CBRC and SAFE. Disagreements among these departments are now rife.

The CSRC is comparatively cool toward the QDII. Its Chairman Shang Fulin once remarked that China will be prudent about QDII.

The securities regulators might well be disturbed by the potential impact on the mainland stock market when overseas investment access is opened.

A source close to the CSRC said speculation about QDII right now is inappropriate, as it could deal more blows to the mainland stock market. If the authorities are determined to give it the go-ahead, then ordinary investors might suffer the most.

The tumble China's stock market has taken since May indicates that investors just say no to QDII. The Shanghai composite index dove to the year's low in June and investors are beginning to panic.

Although China's tightening economic policies and fractured speculative funds are also factors dragging down the market, QDII has certainly added some weight.

Establishing thresholds for QDII candidates is also a concern for regulators. Compared with their upbeat foreign counterparts, domestic securities companies seem to be quibbling.

An official with a large domestic securities company eyeing QDII business said his company has kept close contact with regulators, but now the hope seems dim. He explained that so far, only a few domestic securities houses have opened overseas branches and the foreign giants dwarf those branches.

Small and medium-sized securities companies show no interest in QDII. As one company official said, the domestic market is still awaiting development, so why bother with the overseas market?

But other domestic companies are hopeful about obtaining a QDII license. These include insurers, pension fund managers and trust firms.

Many feel that the QDII scheme would be best tried out step by step, choosing a few qualified domestic institutions as pilots to enter the overseas markets while the authorities keep a close eye on capital flow. The result of the experiment would decide how soon the QDII scheme would be expanded to other companies.

The National Council of Social Security Funds (NCSSF), which handles nearly 140 billion yuan (US$16.9 billion) in strategic social security reserve funds, is a pioneer in the sector.

The NCSSF obtained State Council approval to invest in overseas capital markets in February and has been working with the government to design detailed regulations to implement the plan, including the choice of fund managers and custodian. It recently acquired US$500 million of the initial overseas investment quota.

(Beijing Review July 8, 2004)