China is moving to open its capital markets along with the gradual liberation of its capital accounts.

In the last few weeks, four overseas financial institutions, including UBS AG, Nomura Securities, Morgan Stanley and Citigroup Global Transaction Services, have become the country's first qualified foreign institutional investors (QFII).

The market is speculating that these financial giants, together with a few in the wings awaiting final approval from the authorities, will bring an immediate US$1.5 billion into this country.

China, with its long-term goal to forge sound and efficient capital markets, will have to eventually liberalize its capital accounts.

But any abrupt liberalization of these will inevitably pose a threat to the country's underdeveloped financial regulatory system.

Therefore the authorities have opted for a step-by-step strategy - of which the launch of QFII plays a pivotal role - to gradually ease their regulatory control on capital accounts.

According to international experience, the QFII scheme is particularly suited to the conditions of developing countries, whose underdeveloped capital markets are in transition to be opened to foreign investors.

The QFII scheme will allow foreign institutional investors, who meet specified requirements, to invest in domestic capital markets.

The investment activities of these investors will fall under close supervision of domestic regulators.

And their received capital gains, dividend payments and interests will need to obtain approval before being transferred overseas.

The QFII investors will be required to file their annual financial reporting of their QFII investments, inward and outward remittances and foreign exchange conversions.

The QFII investors will also need custodian banks to act on their behalf to apply for, and open, Chinese currency settlement accounts.

Successful experiences in applying QFII schemes have been accumulated in a handful of developing economies, including China's Taiwan, South Korea, India and Brazil.

QFII schemes vary among the afore mentioned economies and demonstrate the different outcomes, which in turn impact on their capital markets.

In terms of the QFII qualification, China's Taiwan usually grants licences to banks, insurance companies, fund management firms and securities companies while India prefers to attract funds with long-term, steady investments.

The Chinese mainland will likely go for a QFII scheme with prudent regulation, considering the unsoundness of its capital markets.

In terms of the QFII approval and registration, the Chinese mainland has adopted a framework similar to that of Taiwan, which has an approval procedure comparatively transparent and efficient.

In terms of the QFII investment scope, all the countries have limited foreign investors from entering specific markets or sectors.

The Chinese mainland has also imposed on QFII investors specific time and quantity limitations - instead of using tax incentives as some others do - in transferring funds overseas.

QFII and liberalization of capital accounts

China's capital accounts are set to be liberalized. It is seen as a critical step in the country's financial reforms.

Currently the authorities have liberalized more than 40 items under the capital accounts, leaving only 10 under strict control.

The controlled accounts include those permitting Chinese residents to invest in overseas corporate shares, issue debts to overseas investors and buy into overseas bonds.

The implementation of the QFII scheme marks a critical step for China towards a final liberalization of its capital accounts.

To fully open its capital markets to foreign investors, a country has to go through three phases.

First, the country should allow foreign investors to buy into the Country Funds or special categories of shares, such as Chinese B shares.

Second, the country should give limited access to foreign investors with systems such as the QFII scheme, which could stem short-term capital inflows.

Finally, the country should fully liberalize its capital accounts and allow free capital inflows and outflows.

The Chinese mainland, with its foreign exchange regulatory system similar to that of Taiwan, could learn a lot from the successful experience of this island in implementing the QFII scheme.

When Taiwan first launched its QFII scheme, the island had a financial market - in terms of financial products and investor structure - quite similar to the present market on the mainland.

Taiwan's experience shows the QFII scheme can efficiently contain market volatility and therefore stabilize the market.

The influx of foreign institutional investors will inevitably spur the growth of financial derivatives, which could be used to hedge risks.

The implementation of the QFII scheme will also provide a platform for the regulators to improve their supervisory skills.

The QFII scheme will lay a solid foundation for an access to international financial markets.

Taiwan's QFII scheme has significantly improved the depth and efficiency of its financial markets.

Many financial products, such as debts and futures, have developed since its introduction of the scheme.

The scheme has also accelerated the island's progress into an international financial centre.

A similar scenario will likely come to the Chinese mainland, whose self-adjusting mechanism in balance sheets is due to improve.

However, one drawback to the Chinese mainland's QFII scheme lies in its vague principles in building the whole framework.

Unlike Taiwan, which adopts a step-by-step strategy to gradually open its capital markets to domestic trust companies, QFII investors and General Foreign Institutional Investors (GFII), the Chinese mainland does not have a clear future plan.

The author is a professor of finance with Beijing Normal University.

(Business Weekly 06/17/2003 page1)