The Renminbi Qualified Foreign Institutional Investor (“RQFII”) pilot program allows non-PRC institutional investors from certain jurisdictions that have officially implemented the RQFII (the “Relevant Jurisdictions”) to deal in People’s Republic of China (“PRC”) domestic securities using offshore Renminbi (“RMB”). Additionally, because of special RQFII rule provisions, the RQFII program affords broader investment possibilities in some contexts and much greater flexibility not found in its predecessor pilot program, the Qualified Foreign Institutional Investor (“QFII”). Currently, only Hong Kong, London and Singapore (the “Relevant Jurisdictions”) have been announced as eligible jurisdictions under, and have officially implemented, the RQFII program locally—although Taiwan and Paris have also been announced as recipients, they have not yet locally approved the program[1].

The RQFII program is potentially attractive to non-PRC investors keen to deal directly in the PRC onshore securities market as it provides direct access to:

• PRC A-shares and fixed-income bonds of PRC entities not currently available offshore, even with the existence of H-shares or dual listings
• numerous fast-growing Chinese sectors such as healthcare, technology, multimedia and consumer sectors not currently listed outside of the PRC with valuations Bloomberg estimates are trading at price-to-earnings multiples of eight times for 2014 and seven times for 2015, which are approaching historical 10-year lows; and
• onshore fixed-income bonds whose yields are higher even than those of PRC offshore bonds, which were already the best-performing bond market in Asia in 2013 with average returns of 6%.

RQFII versus QFII
Before the introduction of the RQFII program, a non-PRC entity that wanted to deal in securities issued in the PRC domestic market would have required approval as a QFII under the QFII program.  The RQFII has not eliminated the QFII program, which is still a useful avenue into the PRC domestic securities market for certain types of institutional investors, but the programs differ in significant ways that are material to certain investors, among them (i) currency of settlement; (ii) investor eligibility parameters; and (iii) suitability considerations, including flexibility of investments and repatriation of proceeds.
Table I shows a summary comparison of the key requirements of the RQFII and QFII programs.

RQFII Application Process
Table 2 sets out the timeline for a typical RQFII application process through to listing. As the RQFII program and uses of it in the form of open-ended funds and listed vehicles is still fairly new, it is an optimistic timeline and draws substantially from its practice and use in Hong Kong, which is the only one of the Relevant Jurisdictions to have both authorized and listed such funds.

Potential Uses of RQFII in an International Investor’s Portfolio

• Developing new products based on onshore PRC securities
  • RQFII Undertaking for Collective Investment in Transferable Securities (“UCITS”) funds invested solely in PRC-listed securities such as fixed-income bonds and/or PRC A-Shares
  • EU alternative investment fund invested in PRC listed securities
• Tapping a previously non-existent or non-available market
• Middle-Eastern, African and South American investors with a large appetite for Chinese products
• Entities that may not by themselves be able to satisfy RQFII eligibility requirements or the costs of compliance and maintenance of RQFII license holders
• Listing for purposes of liquidity
• Dual listings
• RQFII funds domiciled in Luxembourg and Ireland
• RQFII exchange-traded funds (“ETFs”) listed on the New York Stock Exchange
• Passive as well as actively managed funds
• Developing products based on a combination of different factors depending on needs and purposes

Considerations in the Choice of a Relevant Jurisdiction for a RQFII License Applicant

Where should you apply for your RQFII license—Hong Kong, London or Singapore?

• Less of a strategic than a practical decision with the blurring of borders and barriers. Purely from the perspective of convenience, if an entity is already licensed or located in one of the Relevant Jurisdictions, it makes commercial sense to apply for its RQFII license from that jurisdiction. However, strategic considerations may include the product that the firm wants to launch, the familiarity of the process in each jurisdiction and the overall RMB quota available in that jurisdiction.
• Consider your distribution strategy and investor base
  • UCITS products clearly best-launched from a European jurisdiction if target investors are European
  • Additionally, for the UCITS fund to attract investors outside of Europe, they may consider a primary or secondary listing on an Asian stock exchange
• The familiarity of regulators and service providers with the product being offered is also a relevant consideration, as it can minimize delays and costs.
• Hong Kong has been the traditional home for ETFs
• Since the RQFII program has been in place and operating in Hong Kong before any of the other Relevant Jurisdictions, a robust and skilled infrastructure in Hong Kong has arisen to support RQFII funds as Hong Kong custodian banks, lawyers, auditors, administrators, compliance and record-keeping specialists and other on-going maintenance service providers have been dealing with RQFII procedural and administrative issues since 2011.
• How long is the structure required or anticipated to be required?
• What is the applicant’s investment focus and how flexible is it? For example, if listing an ETF is the focus, which stock exchange would give you the best liquidity? Which market would give you greatest access to offshore RMB? If you needed to apply for greater quota as a fund, what sort of (further) authorizations and/or disclosures would be required, and how easy would it be to do this?
• What are the additional burdens or benefits of listing in a third jurisdiction? What is the purpose of that listing? Would the additional costs outweigh the benefits?
• Does a license in a Relevant Jurisdiction add any benefit to the focus of the applicant’s group of companies as a whole?
• Which jurisdiction would have the most skilled service providers to deal with RQFII follow-up issues down the road?
• Ultimately, the investment quotas granted to each jurisdiction may be the most important issue to consider, as a prospective RQFII applicant will naturally not want to establish in a Relevant Jurisdiction that has exhausted or will likely soon exhaust available quotas. With a plethora of Relevant Jurisdictions competing for RQFII funds business, potential RQFII applicants first entering the RQFII market should carefully their particular situation in both the long and short term in order to determine the most suitable Relevant Jurisdiction from which to make an RQFII application. Important considerations would likely include the following :-

Issues

Need for innovative investment thesis
Simply having access to the PRC domestic securities market will not ensure the success of an RQFII applicant. Fund managers need to identify and/or develop specialized investment products tailored to clients’ needs.
Potential Impact of PRC-Hong Kong mutual fund recognition and mutual stock market access
Some observers believe these developments may actually enhance PRC fund managers’ interest in the RQFII program because in order for the RQFII program to work successfully, offshore RQFII managers would require the specialized investment skills and techniques of onshore PRC investment professionals with expertise in PRC assets. In any event, these issues are currently moot as the Hong Kong-PRC mutual fund recognition program has been announced as imminent for the better part of a year but has yet to be implemented, while the Hong Kong-PRC mutual stock exchange access is slated to go live by the end of year at the earliest.

Lack of clarity in interpretation and application of the RQFII program rules
With PRC laws in general, much needs to be derived from observation, repeated practice without adverse reaction and general public consensus. Some specific areas of uncertainty have been discussed above, and there are many other areas in which knowledgeable practitioners’ advice is a necessity. 

Among other things, there are questions as to the definition of “principal place of business” in a Relevant Jurisdiction (a key requirement for RQFII eligibility). On another note, what exactly is an RQFII open-ended fund since no specific definition has been provided, and why the distinction between QFII open-ended China funds and RQFII open-ended funds? The practical way to deal with such uncertainties has been to watch other RQFII applicants in action or to take the leap with fingers crossed. So far, there has been no indication otherwise from the PRC regulatory authorities and as the RQFII program gains traction, more clarity and certainty will surely arise.

Withholding tax
Another stumbling block had been the taxation of profits, especially that on capital gains, which has now been clarified by the PRC regulators to some extent. Earlier this year, China Asset Management Company announced that it had obtained a Hong Kong Resident Tax Certificate from the Inland Revenue Authority of Hong Kong which exempts its China AMC CSI 300 Index ETF from a 10% withholding tax on unrealized and realized capital gains derived from all its disposals of China A-shares other than those A-Shares in “land-rich companies” in China. As a result, the fund reversed all provisions it had made for withholding tax since the date of inception of the fund in respect of its trading in non-land-rich A-shares although, as a small proportion of its holdings were in land-rich companies, it would continue to make the necessary 10% withholding tax provision for those holdings only and, going forward, would cease to make any provisions for its trading in non-land-rich A-shares and would apply this position retroactively from the date of the inception of the fund. It is anticipated that the China Securities Regulatory Commission (“CSRC”) and SAT will likely address this issue formally in the coming months.

One must also bear in mind that amendments to the rules and “practice” of the RQFII program may not necessarily be reflected in the actual rules or legislation themselves as they would be elsewhere, but may end up being “accepted” by virtue of repeated usage or announcements and press releases.

Time lag
The technical details for London’s RQFII have still to be clearly ascertained—and the only truly tried-and-tested model is the Hong Kong model, which requires funds to be domiciled in Hong Kong. This puts foreign managers at a distinct disadvantage to Chinese asset managers which are able to obtain approval and launch their products immediately, irrespective of demand. However, the target market for RQFII products is different from that for direct Chinese fund products, which foreign investors could not access by themselves so this is, perhaps, an unfair comparison and is, in any event, better than no access at all. That RQFII ETFs have been listed in New York, Ireland and Luxembourg indicates that this is merely a temporary blip that can be overcome and as the program develops, the timing issue will resolve itself.

Time limits for investments
While the RQFII license is granted by the CSRC to the fund manager itself, the quota is obtained from the State Administration of Foreign Exchange (“SAFE”) on the basis of the relevant product that the fund manager wants to launch. At the same time, the SAFE requirement is that a quota be obtained within one year of the RQFII license being obtained. This creates an issue of developing an RQFII product, obtaining regulatory approval for that RQFII product (if an RQFII open-ended fund) and obtaining a quota before the year expires, failing which the SAFE has the right to revoke or reduce the quota.

Requirement for RMB
There is a presumption that a steady supply of offshore RMB is necessary for RQFIIs to purchase PRC assets. However, since the introduction in March 2012 of RQFII ETFs, virtually all RQFII ETFs are traded in two or more currencies; a Hong Kong-managed New York-listed ETF would trade in U.S. dollars on the New York Stock Exchange, which are then converted into RMB in Hong Kong before the ETF purchases the PRC securities in the PRC. The continued need for currency conversion and hedging in the meantime will require that RQFII funds consider the application of financial markets regulations such as the European Markets Infrastructure Directive and the U.S. Commodity Exchange Act.

On the basis of these uncertainties, it becomes doubly important that interested parties contact advisers, such as legal advisers familiar with the process on their intentions, and work closely with such advisers to ensure that they do not misinterpret current practice and provisions or inadvertently run afoul of practice (especially when this is changing on a regular and very rapid basis) and to ensure that the RQFII process flows smoothly and possible issues can be anticipated and dealt with efficiently and seamlessly.

Conclusion
As China pursues efforts to internationalize the RMB, there are expanding opportunities for international investors to obtain exposure to onshore PRC assets and funds and hedge their exposures in offshore RMB markets. The RQFII program marks a potentially important step in that internationalization and would appear to be the way to go, as opposed to the QFII, as recent announcements as to the incentives to be offered for the RQFII program would indicate. The CSRC, the SAFE and the People’s Bank of China are aware of the need for investors’ confidence and have indicated that they are addressing the issues affecting the RQFII program, among them, taxation, repatriation and access to the fixed-income markets as a top priority, and are likely to resolve them shortly. The RQFII application process has been very much streamlined and clarified with the CSRC announcing an unprecedented 60-day performance pledge in the processing of RQFII applications. The speed in quota issuance for the RQFII and QFII programs and the liberalization of access to these programs has left observers in no doubt as to the PRC regulators’ intentions. Market participants need to start planning their involvement in the market and mastering the technical complexities attached to the RQFII program now so that they are not left scrambling for a position when demand hits.

Notes:
[1] Hong Kong currently has the largest RQFII quota of RMB 270 billion, followed by the UK and France with RMB 80 billion each and Singapore with RMB 50 billion. Taiwan is expecting RMB 100 billion.