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The general consensus among the global financial community is that China is set for explosive growth over the coming years, and two decades of free market reforms have made the economy increasingly open to investment from foreigners. Accordingly, it is becoming easier for financial institutions, investors and corporations with an eye on the emerging Chinese market place, with its increasingly affluent population, to gain exposure to China either directly or indirectly.

Shares

There are a number of ways that investors can get exposure to the Chinese market, and one of these is through the purchase of shares. For example, simply by investing in those large multinational corporation with major Chinese involvement, you are getting some exposure to the Chinese market.

Another more direct (and riskier) way would be to purchase shares in Chinese companies themselves. As part of the reforms designed to facilitate a tradable equity market, China has established two stock exchanges, in Shanghai and Shenzhen, while around 180 of the mainland’s largest enterprises are also listed on the Hong Kong Stock Exchange.

Most international fund managers and institutional investors choose to buy stakes in the Chinese firms listed on the HKEx because the Chinese equity markets still remain something of an unknown quantity despite the sector’s potential for growth. Therefore, much of the trade in Chinese securities is conducted from Hong Kong, which has been a well established and well regulated financial services jurisdiction for a number of years, so that issues over corporate governance and the viability of listed stock are not as apparent as on the mainland.

The Chinese financial authorities have created several share classes, some of which are open only to domestic investors. These classes are as follows:

A Shares: Local shares quoted in yuan (or renminbi) on the Chinese stock exchanges and available directly only to Chinese nationals

B Shares: Local shares quoted in HK$ on the Shenzhen stock exchange and quoted in US$ on the Shanghai exchange; available to foreigners and certain classes of domestic investor

H Shares: Chinese registered firms trading in Hong Kong and quoted in HK$

N Shares: Chinese firms listed on the NYSE and traded in US$

Red Chips: Shares of offshore companies with direct or indirect substantial ownership by a Mainland Chinese entity; generally traded in Hong Kong

P Chips: Shares of companies majority-owned by entrepreneurs from Mainland China; generally listed in Hong Kong, but may be listed on the Nasdaq or elsewhere.

Thankfully, for the smaller private investor, there are an increasing number of mutual funds and similar vehicles which track the performance of Chinese equities. In a way, this option represents the best of both worlds by giving investors direct exposure to Chinese equities, but at a fraction of the cost and at a much reduced risk. Figures reveal that recent performance of China funds has been impressive. According to fund industry consultants Lipper, some 22 China region funds with assets totalling $1.94 trillion had average returns of 5.19% in the third quarter of 2004, returning 16.52% over the year. Two and three year returns stand at 29.05% and 18.96% respectively.

New products are increasing access to the Chinese equity markets for the smaller investor. One recent example is the iShares FTSE/Xinhua 25, launched on the London Stock Exchange in October 2004, which is also listed on the New York Stock Exchange. This exchange traded fund (ETF) became the first in Europe to give exposure to Chinese equities and the fund will track the performance of red chip and H shares listed on the Hong Kong Stock Exchange.

Another groundbreaking fund listed on the Hong Kong Stock Exchange was also launched the following month based on the FTSE/Xinhua A50 Index, giving international investors exposure to China’s domestic A shares for the first time.

Investing through an ETF like the FTSE/Xinhua 25 has many advantages. It allows investors more direct access to Chinese growth than simply buying shares in a multinational with a presence in China, while taking away much of the risk and hassle of investing directly in China’s volatile and fragmented market place. Administration costs are also modest at 0.75% and the fund is shortable for those investors who are not so bullish on the Chinese economy in the coming years.

For those with a few million in spare change burning a hole in their pocket, there is also the hedge fund option. As well as specialist China hedge funds looking to exploit growth in small and mid-cap stocks, emerging market hedge funds are also likely to have a degree of exposure to China. While emerging markets hedge fund strategies have produced some impressive returns in recent years, the sector is quite volatile and is therefore fairly high risk. Bear in mind also that the high minimum investment levels (variable, but usually around the US$1 million mark) preclude hedge fund investment for all but the wealthiest investors, and performance fees can also be expensive.

Company investment

China’s free market reforms have encouraged foreign companies to invest directly in the country, particularly in manufacturing where firms have for a number of years sought to take advantage of its low cost, educated labour force. However, as China’s economy grows and its society becomes ever more affluent, urbanised and consumerist, foreign companies are now looking to China as a market in itself as opposed to a mere manufacturing base.

China’s membership of the WTO has also forced the pace of its free market reforms, and the government, somewhat reluctantly, is in the process of reviewing and reforming many laws that acted as a barrier to foreign investment and trade, both in financial services and manufacturing. However, foreign firms looking to establish a physical presence in China will still find the process long-winded and bureaucratic as the Chinese government tend to encourages certain forms of investment over others. However, this regulatory burden on foreign firms is mitigated by some significant tax breaks and tax holidays lasting up to ten yeas in many cases.

The Chinese government has promulgated a series of laws and statutes concerning the establishment, operation, termination and liquidation of foreign-invested enterprises. These are enshrined in three basic laws: The Law of the People's Republic of China on Chinese-Foreign Equity Joint Ventures; The Law on Chinese-Foreign Contractual Joint Ventures; and the Law on Wholly Foreign-Owned Enterprises.

The establishment of enterprises with foreign investment is subject to project-by-project examination, approval and registration by the government. To give a taste of how this process works, prospective foreign investors can expect to embark on the following paper trail:

First, prospective foreign corporate investors must submit a project proposal to the relevant department for approval. Then, a feasibility study must be submitted to the planning department before legal documents, such as contracts and articles of incorporation, can be signed. However, the process doesn’t stop there. Once signed, the contracts and articles of incorporation must be submitted to the examination and ratification department, which will then issue an Approval Certificate for Enterprises with Foreign Investment after the final nod has been given by the Ministry of Foreign Trade and Economic Cooperation.

For investments involving a sum of less than US$30 million, applications can be directed to the authorities at the local levels, whether that be provincial government, municipalities, autonomous regions or cities. When an investment exceeds this amount, the project application and feasibility study report will be examined and approved by the State Development Planning Commission or the State Economic and Trade Commission, while the contract and articles of corporation will be examined and approved by the Ministry of Foreign Trade and Economic Cooperation.

Thankfully, to help ease this rather bureaucratic process for foreign investors, many local governments have established foreign investment service centres, which offer foreign investors a ‘one-stop shop’ service ranging from legal consultation to procurement of project approval.

Hong Kong and CEPA

Another route into the Chinese market, touched upon earlier, is via Hong Kong. Although Hong Kong is now classified as a ‘Special Administrative Region’ of China, it retains a certain degree of autonomy from Beijing and its obvious proximity to the mainland makes it an ideal entry point for firms wishing to do business with China. Furthermore, the Closer Economic Partnership Arrangement (CEPA), a trade deal between Hong Kong and Beijing that seeks to remove tariffs and other barriers to trade in goods and services, has great benefits for foreign firms based in the SAR.

By 1st January 2005, the CEPA II deal will remove tariffs on 1,087 categories of goods exported from Hong Kong to the Chinese mainland. It also removes or reduces geographical, financial and ownership constraints on 18 service sectors including professional services, communications and media, financial services and trade related services. Importantly, these apply to companies of any nationality provided the firm is incorporated in Hong Kong, has operated there for a minimum of three years, is liable to pay tax in the territory, and employs at least 50% of staff locally.

Overseas firms without a presence in Hong Kong are still able take advantage of the CEPA provisions by outsourcing to, or partnering with, a qualified Hong Kong-based manufacturer or service provider. Foreign manufacturers can achieve this by satisfying rules of origin requirements which essentially means that goods must be ‘substantially changed’ in Hong Kong to qualify. Overseas service providers meanwhile, can partner with or invest in a CEPA qualified firm to gain greater access to the mainland market.

So, to summarise, there are many ways in which investors can capitalise on growth in China, whether that be at the individual, institutional or corporate level and as the economy continues to grow, and the government forges ahead with free market reforms, the investment opportunities are likely to expand accordingly. However, as with any other investment, sufficient attention should always be paid to the potential risks, and while the consensus is that China is set for a boom, a la post war Japan, its economy will not be immune to externally influenced shocks, and the destiny of the free market remains very much in the control of the central government.