Mutual Recognition: New Horizon for China, Hong Kong, and Foreign Fund Houses?
When former Bank of China chairman Xiao Gang (pictured left) took over as chairman of the China Securities Regulatory Commission (CSRC) in March, he inherited a long list of still-in-progress capital market reform initiatives from his predecessor Guo Shuqing. One stands out for its potential impact on the fund industry in mainland China and Hong Kong: a mutual recognition funds platform that would provide for a streamlined “visa” process for cross-border distribution.
Compared to China’s recently announced RQFII2 program for individual investors and enhancements to the country’s existing RQFII program, the cross-border platform is more complex to implement, but also potentially very lucrative for foreign fund houses that already have a presence in Hong Kong or China — or are thinking about setting one up. For this reason, mutual recognition has become a popular topic of discussion, most recently at the AsiaHedge Forum 2013 in April, where 300 hedge fund managers, prime brokers, and other industry participants from around the world discussed the extent to which the initiative could become a game changer for the global fund management industry and, in particular, how it might impact popular fund domicile jurisdictions like Luxembourg and Ireland.
The push for mutual recognition began taking shape in November 2012, when mainland China and Hong Kong formed a working group to explore the issue. Given the complexity of the undertaking, many issues remain unresolved. Shortly before leaving his post, the previous CSRC chairman said that “achieving mutual recognition of registered funds between Hong Kong and the mainland, cross-border distribution, and cross-listing of products on the exchanges both in Hong Kong and Shanghai” was an item on his to-do list — but he did not give more details.
In a speech in January, Alexa Lam, deputy chief executive officer of Hong Kong’s Securities and Futures Commission (HKSFC), added some substance with regard to how things might play out. Lam, who also serves as executive director of of HKSFC’s investment products division and oversees international engagements and market development efforts for Hong Kong and China, said she envisions a streamlined visa application process for funds from either side of the border to be authorized for cross-border distribution. She stressed that this would not be comparable to the “fund passport” protocol commonly associated with the European UCITS regime. Her proposal is that qualified HKSFC-authorized funds domiciled in and operating from Hong Kong would enjoy status as “recognized Hong Kong funds” and qualified mainland CSRC-authorized funds would enjoy the status of “recognized mainland funds.” With this status, cross-border distribution would only be subject to a fast and simple review by the local regulator, and the “recognized fund” could be sold to investors across the border. She noted that this is not really something new: Such mutual recognition arrangements already exist with Taiwan for exchange-traded funds and with Australia.
The ability for the Hong Kong fund industry to tap the huge savings pool in China would be a tremendous step forward and would expand industry assets manifold. In addition, such a move would inevitably encourage foreign fund houses that have not yet established a presence in Hong Kong to revisit the business case for setting up shop. For Hong Kong retail investors, product offerings would naturally be enriched with this new cross-border arrangement: There are more than 1,100 CSRC-authorized funds covering various asset classes and strategies managed by professionals on the ground.
Mainland China investors stand to benefit from mutual recognition as well. HKSFC-authorized funds cover a wide selection of asset classes, countries, markets, strategies, and currencies. Mainland fund houses, by distributing in Hong Kong via the platform, could learn more about the preferences and needs of international investors, as well as international practices and standards — all while competing with their counterparts in Hong Kong who have had seasoned international experience spanning many decades.
This mutual recognition platform would also further the Chinese central government’s goal of developing the RMB as an international currency. While trade flows in RMB are huge and growing, and the RMB Foreign Direct Investment scheme remains active, the pool of RMB-denominated investment products is still shallow. Growing the pool is indeed an important next step in the internationalization process. “If only we get a fraction of mainland authorized funds to Hong Kong, we would immediately add an exciting new depth and richness to our RMB product pool, boost the appeal of the currency outside the mainland, and move closer to the goal of securing Hong Kong’s position as the preeminent offshore RMB center,“ Lam said in her speech this January.
Hong Kong has thus far served as the preeminent offshore RMB center, with its 720 billion RMB deposit base (as of year-end 2012), RMB-denominated (“dim-sum”) bonds, bond funds, and RQFII funds, as well as listed products like stocks, REITs, RQFII ETFs, and gold ETFs. However, other centers that naturally accumulate large RMB pools — including Singapore, London, Taipei, and Sydney — are also working hard to grow as offshore RMB centers.
Hong Kong’s Financial Secretary John Tsang is also contributing to Hong Kong’s attractiveness as a fund management center. In the 2013–14 budget delivered earlier this year, the profits tax exemption for offshore funds was extended to include transactions in private companies that are incorporated or registered outside of Hong Kong (with the condition that these do not hold any Hong Kong properties nor carry out any business in Hong Kong). This makes up for a shortfall in Hong Kong’s Profits Tax Exemption for Offshore Funds Ordinance, which is considered to have unduly hampered venture capital and private equity funds. In addition, consultation for legislative amendments to allow investment funds to take the form of an open-ended investment company in addition to the trust structure will soon be underway. This amendment is designed to attract more traditional mutual funds and hedge funds to domicile in Hong Kong.
The impact may well be felt in Europe. Some 60% to 70% of the HKSFC-authorized retail funds sold in Hong Kong are UCITS funds domiciled in Luxembourg and, to a much smaller extent, in Ireland. Will the China–Hong Kong mutual recognition platform prompt some of these funds to re-domicile in Hong Kong in order to target the huge and fast-growing savings pool in China? Only about 10% of Luxembourg-domiciled funds are distributed in Hong Kong, according to industry sources, so the impact, while significant, is not going to be overwhelming. The situation in Ireland appears to be similar. Still, expansion and enhancement of the existing Qualified Domestic Institutional Investor (QDII) scheme and the launching of a pilot Qualified Domestic Individual Investor program, which Guo refers to as QDII 2, could benefit Hong Kong as well as Luxembourg and Ireland.
There are many operational issues yet to resolve and much progress yet to be made on the march toward mutual recognition of registered funds between Hong Kong and the mainland. Meanwhile, the recently established Financial Services Development Council in Hong Kong and the State Council–sanctioned Qianhai Shenzhen-Hong Kong Modern Service Industry Cooperation Zone — which is reportedly aspiring to become the “Manhattan of the Pearl River Delta,” designed to complement and expand Hong Kong as a financial center — have demonstrated the governments’ resolve to build up Hong Kong as the preeminent offshore financial center with a key focus on the RMB.
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