SURVEY: Opening the gate of China

After decades of domestic growth, the PRC is gradually letting the international community in – but contradictory policies make it a difficult market to tackle

The past year has seen China liberalising – in gradual iterations – its financial and insurance sectors. The process has been slow and careful, but a range of reforms are sending the signal to foreign financial institutions that attitudes are changing.

Against this backdrop, IFLR chose to poll readers on the strategies they're adopting, barriers they still face, and what else needs to happen to smooth their path.

The results show the practical difficulties banks and asset managers face when expanding into China. Respondents offered frank feedback on the day-to-day issues they come across, and how existing and future policies can better motivate foreign financial institutions to access the PRC financial markets.

METHODOLOGY

IFLR distributed this survey to readers at banks, asset managers and law firms between January and March 2019. All survey respondents were offered anonymity to encourage in-depth and honest discussion of the challenges. Extensive follow-up interviews were completed to provide a more comprehensive analysis of some key issues. Respondents included international banks, asset managers, funds and private practice lawyers in banking and finance based in the Greater China region. While the more structured responses to the poll questions provide interesting statistics, a real sense of in-house lawyers’ concerns emerged from the interviews. The topics raised in those interviews form the basis of the report.

While foreign banks have been investing in retail and commercial banking in China for the past decade, many sold their equity interests between 2009 and 2016 due to challenges in the post-financial crisis global environment. Many also struggled to stand out in the PRC market. On the other hand some banks, including HSBC and the Bank of East Asia, have remained committed.

Foreign banks can operate in China either as subsidiaries or as separate legal entities with their own governance, risk management and capital requirements. These are known as wholly-foreign-owned enterprises (WFOE), and Sino-foreign joint ventures (JV).

But foreign banks have found it increasingly difficult to compete with domestic players, especially in retail and commercial banking. Seizing opportunities in under-served areas, such as customers looking for overseas investments, is key. Meeting a wide range of regulatory requirements that are continuously changing is also a challenge, as indicated by more than 80% of survey respondents.

According to the China head of a US bank which has a Sino-foreign JV, deciding what type of firm to set up depends on the bank's strategy. "The benefit of a WFOE is that the foreign bank can have absolute control, including of its business strategy, recruitment and governance, while JVs get the benefit of client base replication," he says. "WFOEs can't develop as fast as JVs."

1. What is the greatest market driver that has motivated foreign financial institutions to access China’s financial markets?

The source adds that patience truly is a virtue. "Even after the initial setup, sub licenses are required from the China Securities Regulatory Commission (CSRC) and China Banking and Insurance Regulatory Commission (CBIRC), and it can take a number of years of investment before you see any gains," he says. For foreign investors in commercial banking, for instance, the capital adequacy ratio must be at least equal to the average for its place of registration, and no less than 10.5%.

Liu Fei, partner at Jingtian & Gongcheng in Beijing, says that Chinese regulators still have a fairly cautious attitude towards foreign financial institutions. "Launching domestic branches or sub-branches still depends on the review and approval of administrative departments, and exact procedures, timescales and results are uncertain," says Fei. For foreign banks new to the Chinese market, they also need to get familiar with the local regulatory system and business environment. Particularly challenging compliance issues include staff behaviour that may not be up to international standards, such as attitudes towards anti-money laundering requirements, and compliance with foreign exchange manage-ment.

Plus, entering the market is only the first step. "If banks want to expand beyond deposit-taking, they may need to apply for other licences such as bond trading and underwriting, which are subject to separate approval by regulators," says Yin Ge, partner at Han Kun Law Offices in Shanghai. "And given the restriction on foreign banks' business scope, they may find it difficult to compete with domestic banks or other well-established foreign peers." In her view, the most challenging compliance issue is keeping up with China's ongoing regulatory reforms, which cover a wide range of issues, from shareholding to capital adequacy to asset management.

Benjamin Quek, head of corporate banking at OCBC Wing Hang Bank in Shanghai, says that Chinese banks have spent considerable time developing their networks, services and customer base, so have obvious competitive advantages in the local market. That makes it difficult for a newcomer starting from scratch to make inroads.

"Localisation is always a challenge," Quek explains. "Foreign banks in China need to understand the local market, culture and customers, which vary so widely across the 23 provinces in China, and even within cities in the same province."

He remains optimistic about initiatives such as the Guangdong-Hong Kong-Macau Greater Bay Area (GBA). The GBA is a plan to create links between the nine cities and two special administrative regions in the Pearl River Delta to create more economic opportunities and cohesion. "The GBA is not only one of Asia's most dynamic regions, but a leading growth engine for Greater China, which will bring huge opportunities for foreign banks," he says.

Consumer banking is generally not an easy area for foreign banks because most do not have the benefit of a branch network or brand recognition. However, there are opportunities on the wealth management side, especially in product structuring.

BNY Mellon's country executive for China, Sam Xu, adds that as the second-largest economy in the world, the growth prospects for banks in China are enormous. Yet even though foreign banks have been in the country for over 20 years, they make up less than two percent of the market.

"Foreign banks need to be very clear about their specialty and target market," says Xu. "They need to think critically about their positioning and niche." Foreign banks must also be able to navigate the regulatory environment. "From market entry to licensing, the regulatory requirements are complex, and often deviate from international practices," adds Xu.

2. What is the biggest regulatory barrier for foreign financial institutions interested in increasing their ownership stakes in Chinese financial institutions?

All survey respondents view 2019 as a turning point for Chinese asset management. One major shift is the Special Administrative Measures for Foreign Investment Access (Negative List for Foreign Investment Access), which came into effect in July 2018. It permits foreign control of securities firms, fund management companies, future companies and life insurance companies in China.

Foreign investors are allowed to take controlling stakes of up to 51% in these types of financial institutions, with a further loosening by 2021 – though nothing is set in stone yet. Previously, the ownership stake had been set at 25%.

Additionally, the CBIRC announced in August 2018 that management rules on overseas financial institutions' investment in Chinese banks are removed, and that foreign companies are to be treated in the same way as local companies. Some foreign asset managers have opted to set up JVs with local partners for public funds, while others have set up private securities fund management businesses through investment management (IM) WFOEs. They largely remain marginal players in the wider market.

Foreign banks such as Nomura, JP Morgan and UBS have begun to raise their shareholdings in their asset management businesses in China in the past year. In November 2018, UBS raised its stake in UBS Securities from 24.9% to 51%, while JP Morgan and Nomura were given regulatory approval to set up majority-owned brokerage JVs in March 2019.

More than 80% of survey participants cite regulatory uncertainty and a lack of clarity in approvals processes as the biggest barrier to access.

3. What is/will be the most helpful initiative to access China’s financial markets?

A key issue here is competition law. According to Ma Chen, partner at Han Kun Law Offices in Beijing, foreign financial institutions should be aware of the risk of triggering the need for a merger filing with the State Administration for Market Regulation (SAMR). Ma explains that under the Anti-Monopoly Law, turnover thresholds for merger filings include prior fiscal year aggregate business turnover (RMB10 billion ($1.4 million) turnover worldwide, or RMB2 billion turnover in China). Financial institutions are permitted 10 times the standard threshold amounts.

SAMR may impose administrative penalties, with fines capped at RMB500,000 in cases where companies fail to submit merger filings. It also has the power to order firms to dispose of shares, assets and businesses to restore competition.

Zhenyu Ruan, partner at Baker McKenzie in Shanghai, explains that in financial services, industry regulators have imposed restrictions on the number of financial institutions in the same sector that an investor may hold controlling stakes and minority stakes in. Plus, an equity stake increase in an existing joint venture might trigger the regulator's assessment on the party's ownership in any other Chinese financial institutions in which it also holds a minority stake.

"It remains to be seen if a foreign institution may be allowed to continue owning a minority stake in another financial institution in the same sector if there is competing business," says Ruan.

The important thing is knowing how to work with local partners Eleanor Wan, BEA Union Investment Management

Foreign institutions looking to become majority shareholders in Chinese financial institutions should also be aware of corporate governance requirements and articles of association. "Aside from strict disclosure requirements on the ultimate controlling shareholder, Chinese regulators have been actively promoting better corporate governance within financial institutions by introducing concepts and requirements that may not be directly relevant to Sino-foreign joint ventures," observes Ruan. For instance, independent directors – who are not nominated by shareholders – are now required for insurance companies.

Institutions regulated by the CBIRC such as commercial banks and consumer and auto financing companies are now required to specify in their articles of association that their shareholders must inject supplemental capital as and when required by the CBIRC.

Sources say that some of the corporate governance requirements may seem inappropriate or overly cumbersome for JVs owned by just two or three shareholders. The rules state that these requirements are applicable "by analogy", but it is unclear if there is any latitude in deviating from the core rules. So far, regulators have not been able to provide clear and persuasive guidance or clarification on this.

Foreign investors should also be aware that Chinese regulators still impose various qualification requirements on foreign shareholders despite the overall trend of China opening up, explains Fan Lei, senior counsel at FenXun Partners in Shanghai. For example, the CSRC requires that the foreign shareholder of a JV securities company should be a market leader with strong business performance, particularly in terms of its size, revenue and profit over the past three years.

In addition, regulators generally require the foreign shareholder of a JV financial institution to be regulated by a foreign financial regulator who has signed a memorandum of understanding on international supervisory cooperation with China. The CSRC expects total transparency in the foreign applicant's shareholding structure all the way up to its ultimate controller. "Foreign investors should be prepared to fully disclose their ownership structure to the PRC regulator, and as an ongoing compliance obligation, report any significant change in control in future once it has its licence," says Fan.

Although there are no written rules on quota, there would appear to be a cap on licences for individual foreign investors. While local regulators welcome the most reputable global financial institutions to apply, approvals are generally granted on a discretional basis and can sometimes be unpredictable.

More than 70% of participants view RMB internationalisation and the broader growth of Chinese capital markets as absolutely key initiatives in need of further support.

While China's liberalisation is highly anticipated by many, it doesn't come without risks. A key issue is the ability to move capital out of China, along with the broader challenges of competing in a market dominated by state-owned players.

A senior banking source at a foreign bank remarks that as China's financial markets open up, "foreign players will change the essence of the market by enriching the domestic bond and currency markets, and bringing new governance and products". While initiatives such as the inclusion of Chinese stocks into the MSCI and the opening up of China's government bond market to foreign banks are paving the way for foreign capital, the looming risks of US-China trade tensions as well as rising corporate debt and shadow banking issues remain challenges for the Middle Kingdom.

How foreign players deal with these very real issues will be critical to their success. A managing director at a foreign bank says: "For China to fully open up, the RMB has to be convertible. While the currency has gained more traction among institutional investors and is more frequently used in trade, it is still not convertible. The precondition to this is a sound financial system." Although authorities plan to make the RMB convertible by 2020, with increasing geopolitical tensions, this timeline may be optimistic.

Foreign banks need to be very clear about their specialty and target market Sam Xu, BNY Mellon

Survey respondents welcome initiatives such as the Stock Connect, Bond Connect and the Mutual Recognition of Funds (MRF). A major highlight was Stock Connect, a collaboration between the Hong Kong, Shanghai and Shenzhen stock exchanges which allows international and mainland Chinese investors to trade securities in each other's markets.

"It was especially exciting to see banks pull together as an industry to think through where and how stocks are trading and what this means for global clients," says an in-house counsel at an international bank. OCBC's Quek adds that the three schemes have broadened the channels of capital exchange between overseas, Hong Kong and mainland Chinese capital markets and deepened connectivity. The schemes provide more convenient investment channels for overseas investors to invest in the domestic capital market.

Under the Connect schemes, global investors can access two of the 10 largest stock exchanges in the world, Shanghai and Shenzhen, as well as the third-largest bond market, without applying for regulatory approval. Respondents view MSCI's decision to include China-listed shares in its emerging market index in 2017 as testament to the success of Stock Connect. They're also enthused by the inclusion of Chinese government and policy bonds in the Bloomberg Barclays Global Aggregate Bond Index in April 2019.

Meanwhile the MRF looks to streamline the process for Hong Kong and China-domiciled fund distribution. Launched in December 2015, the scheme allows northbound funds domiciled in Hong Kong to be distributed in China. However, challenges remain, including lengthy approval processes for funds, high distribution costs, and a lack of distribution channels.

An important point here is the 50-50 rule that limits the sale of MRF products to Chinese investors to 50% of the value of a fund's units. So far, there are 15 northbound and 50 southbound funds under the MRF. The China Securities and Regulatory Commission (CSRC) takes an average of 34 months to approve funds.

Jackson Lee, China head at Fidelity International, explains that his firm set up representative offices in 2004 and 2007, followed by an operational office in Dalian in 2008. Rather than a JV the company went for a WFOE, and was the first firm to receive a private fund licence in January 2017. Since then, the business has grown into a 30-person team and has launched three funds.

Balancing the global nature of the firm with local needs is key. "As a firm, we have to think about the local and global needs, all without compromising our fiduciary duty as a manager," says Lee. "Being a WFOE is a great way to learn, but we have to focus because there are many opportunities to chase, from asset management and private funds to banking and insurance. We need to maintain the best balance rather than chase everything."

Lee also stresses the importance of good governance. "Knowing how to bring our head office into the China strategy so we're not talking to someone new every time, and having a good understanding of the board and committee are key," he says.

To achieve this, the right team is of equal importance. The competition for talent remains a struggle for global firms.

Eleanor Wan, chief executive officer of BEA Union Investment Management, explains that her firm has established a WFOE in Qianhai, and is currently applying for a private fund manager (PFM) licence. She says it's an extensive and detail-oriented process, and firms must also be able to manage any potential cultural differences.

"The rules are much more descriptive in China than in Hong Kong, and you can't jump steps," she says. "For example, if you make a product application with the Securities and Futures Commission (SFC) in Hong Kong, you can call and ask for the reason behind any delay. But in the PRC, you're not even sure who to call, and it's difficult to predict the outcome." Even within the PRC, business practices can vary; Wan says she has noticed a difference between Qianhai and Shanghai.

Wan warns that the operations and compliance process is tedious, and foreign funds should be realistic about just how much budget will be required.

More than 80% of survey respondents think the fund and asset management industry will see the most significant growth and interest from foreign financial institutions entering China. Global asset managers are eager to access the market via onshore public or private funds, such as investment management WFOEs or JVs with local partners.

4. Which segment do you think foreign financial institutions will be most interested in the Chinese market?

But BEA Union Investment Management's Wan says that for asset management, the main challenge is finding the right partner and maintaining a good relationship. "The important thing is knowing how to work with local partners, and making sure their objectives are in line with the foreign partner's ," she says.

In future, Wan hopes to see private funds' scope expanded. At the moment, foreign firms can only have up to 200 investors, and can only operate under private placement. Chinese asset management is still retail-driven, but there is a long road ahead to a more developed pension system. Wan believes the value of the foreign fund manager is in technology and know-how.

"Although growth has been significant in the last 20 years, market knowledge is not as deep as elsewhere as it's a newer concept," she says. Although the market is huge, there are still many areas that need further development. It's a matter of picking a niche.

"Every day there is competition with domestic firms, but regulation is unpredictable," adds Wan. "The challenge for global firms is explaining local quirks to their US and EU headquarters. The mindset is different because there are so many on-the-ground initiatives – getting support from head office is essential."

For instance, new asset management guidelines encourage banks to set up asset management subsidiaries. Separate product regulations, aimed at limiting shadow banking, will further impact them.

BNY Mellon's Xu believes a more level playing field would go a long way to help encourage foreign financial institutions. "For example, foreign banks are finding their WFOE subsidiaries are compared to local banks – without considering the whole group and head offices – when measuring financial soundness," Xu explains. "It's comparing apples and oranges. Regulators need to take a more holistic view."

There also remains a lack of transparency in some approval processes, says Eugenie Shen, managing director and head of the Asia Securities Industry & Financial Markets Association's (Asifma) asset management group.

For instance, foreign asset managers can own 100% of a private fund management company, but not a public one. According to Shen, many foreign asset managers are hoping to go public in three years when regulators remove the limit.

5. What is the biggest factor that might discourage financial institutions to access China’s financial markets?

Another issue is the onshoring of data. Chinese policy requires that data must only be transferred out of China if there is a genuine need. Further restrictions apply if the data includes information relating to national security, economic development or societal and public interests. "As firms already have global processes in place, it's problematic when they cannot share the data they have in China with their parent company. It disrupts how they operate," says Shen.

Ultimately, foreign firms need to make a profit. "Domestic firms already have home court advantages, so it's important to allow them to distinguish themselves. One way is to allow them to bring best practices, expertise and personnel from abroad," says Shen.

According to an in-house counsel at an international bank, working with regulators to understand the value proportion is key for foreign players, especially when it comes to knowledge transfer. Caps on employee numbers and product variations are barriers to entry. "A key challenge is human capital, especially with the need to hire domestically and get the right skillsets, and ensuring the domestic firm's DNA aligns with that of the parent," he says.

China's constantly-evolving legal and regulatory landscape makes it a minefield for foreign firms, but its opportunities can't be ignored. If regulators really are keen on building a truly international capital market, survey respondents hope their pleas will be answered.