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China Opens Door to Foreign Hedge Funds

China has given foreign hedge funds permission to tap its wealthy citizens inside the country for funds to invest overseas, according to people in the industry.

A broker points to a screen showing various share prices at a securities house in Hong Kong on August 9, 2011.
Laurent Fievet | AFP | Getty Images
A broker points to a screen showing various share prices at a securities house in Hong Kong on August 9, 2011.

The move represents another important step by China to open its capital account — a process that involves dismantling regulations separating China from international markets.

The pace of these reforms has picked up over the past year with a flurry of small initiatives, but the hedge fund move would be among the boldest. As well as creating a new channel for domestic capital to flow abroad, it would give Chinese institutions access to alternative investment strategies — from short positions to arbitrage — which they have lacked.

The reform, called the Qualified Domestic Limited Partner programme, invites hedge funds to apply for licenses to register in Shanghai, two people said. One person said that only the world’s biggest hedge funds, with at least $10 billion assets under management, would be allowed to participate at first.

Laurie Pinto, chief executive of North Square Blue Oak, a London-based investment bank that focuses on China, said that hedge funds were already queueing up to apply for licenses, even though the programme had not been formally announced.

“There’s an amazing distribution potential in China and an amazing need for this product,” he said. “Everyone wants to be in this, but it’s complicated and it’s China.”

As is always the case with economic reforms in China, the hedge fund programme will start slowly and cautiously. A low ceiling, likely to be about $5 billion, will be placed on the amount that can be raised collectively by the institutions that are granted licenses.

Rather than dividing that amount evenly into individual quotas for the hedge funds, they will be invited to fight for as big a slice of the overall amount as possible, according to one person. The objective is to give rise to more market competition than exists in China’s cross-border equity investment programmes, where quotas for each institution are centrally managed by the regulators.

There has been concern in recent months about a rise in capital outflows from China, so the fact that the government appears willing to launch the hedge fund initiative is likely to be seen as a signal of its confidence that the risk is under control. The State Administration of Foreign Exchange, which approves big cross-border transactions, will still have the final say over any money leaving the country.

Chinese investors face an extremely limited array of options. The domestic stock market is seen as a casino, the corporate bond market is under-developed and there are few openings for investing abroad.

As a result, property has been the investment of choice for wealthy Chinese over the past decade, fuelling a real estate bubble that the government is attempting to deflate.

Giving institutional investors more access to foreign investment opportunities is an essential part of the government’s efforts to develop healthier capital markets.

In recent months the Chinese government has also granted foreign institutions bigger quotas for investing in the country’s capital markets and it has expanded the renminbi’s trading band, making it a more flexible currency. Although each of these reforms has been small in impact, analysts say that taken together they constitute a concerted push to experiment with more relaxed capital controls.

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