Last Updated on 17 November, 2020 by Samuelsson
In recent years, Chinese equity and futures markets are becoming more and more attractive to foreign investors because of how fast the Chinese economy, business environment, and financial markets are developing. It was said that the Oracle of Omaha, Warren Buffett, once stated that the 19th century belonged to the British and the 20th century belonged to the U.S., but the 21st century certainly belongs to China. So it seems the Chinese economic transformation has set the eyes of the biggest investors from around the world on its rapidly developing financial markets.
Since China started opening up its economy to the world in 1978, it has witnessed enormous economic growth and has been one of the fastest-growing economies in the 21st century. In fact, according to the Congressional Research Service, over the last three decades, China’s gross domestic product (GDP) has been growing by roughly 10% each year, on average, and over 800 million people have been lifted out of poverty.
At the moment, China is the second-largest economy in the world by GDP and the world’s largest manufacturer. In fact, it is the largest in terms of GDP by purchasing power parity (PPP). It is a major exporter of electronics, medical equipment, machinery, and vehicles. Hence, some of the biggest companies in the world are based in China and are listed on the Chinese stock markets. Although relatively younger than the U.S. stock market, the Chinese equity and other financial markets are growing by the day.
Why do people want to trade Chinese (and foreign) stocks?
You may be wondering if you can trade Chinese stocks. Yes, you can. Since China lifted the restriction on foreign investment in 2002, foreigners can invest in Chinese stocks, but the process is still harder than buying stocks from your domestic market — it is easier for foreigners to invest their local stocks than to buy stocks in China.
The opposite is also true: Chinese citizens can buy U.S. stocks if they choose to because no explicit provisions are prohibiting non-U.S. citizens from investing in the U.S. stock market. There is no citizenship requirement for owning stocks of American companies. In fact, many financial service providers cater to international clients, including Chinese citizens, who wish to buy U.S. stocks.
But why would you want to trade or invest in foreign stocks? What are the benefits and risks associated with trading foreign stocks? Well, here are some of the reasons why some traders and investors try their hands in foreign stocks:
- A great option for diversification
- The potential for s higher returns
- A way to protect wealth from local inflation
- Exposure to a different business environment
This is the process of allocating your investment in a way that reduces your exposure to one asset or market. It is basically a way of managing risk by minimizing your exposure to one form of risk. Thus, investing a part of your capital in foreign stocks, rather than leaving everything in the domestic market, may be a good way to diversify your risk exposure.
The reason is that international markets don’t often correlate with the domestic markets, and there are many reasons for that. Some of the reasons why the markets behave differently include:
- Fiscal/Monetary policy
- Technological specialization
- Cultural/sociological differences
Potential for higher returns
Foreign markets may offer the potential for making a higher return than what is usually obtainable from the domestic market. One of the reasons for higher profit potential is the fact that some of those foreign economies, especially emerging economies like China, are growing at a faster rate than the developed economies.
Another reason for the higher returns is that those emerging economies often have higher inflation rates, and businesses are often set up to make returns that are higher than inflation rates. Hence, the expected returns from investments in emerging economies should be higher than those of investments in developed economies.
It is not always a case of investors from developed economies seeking greater returns in emerging economies. There are situations where investors from less stable economies invest in developed economies even if it offers a lower return potential.
Most of the time, in this situation, the investors are seeking to preserve their wealth from the effects of hyperinflation that is rendering their local currencies worthless. Of course, this may be in addition to the benefit of diversification they get from international investments.
Exposure to a foreign country
There are situations when the sole reason for investing in a foreign market may be just to gain exposure in that market. The reason for that may be to gain political leverage. Some people may also be looking for tax-efficiency.
The potential risks
In spite of all the numerous benefits, there are a number of risks involved, so you need to weigh the risks against the benefits. These are the common risks to consider:
- Exchange rate risks
- Hostile policies
- Lack of liquidity
- Higher trading cost
- Poor corporate governance and higher chances of bankruptcy
- Political risks
Exchange rate risks
The primary risk you face when investing in foreign stocks is the foreign exchange risk. This risk arises because you will have to convert your money to the local currency of the market you wish to invest in. When you want to sell your investment, you have to convert the proceeds back to USD.
Thus, the fluctuations in the local currency can affect your actual return on investment. For instance, if your investment increased by 7% but the local currency has depreciated by 8% by the time you sold your investment, you would have a net loss as your actual return when you convert the local currency back to USD.
One of the major risks associated with some of the emerging economies is that the government’s policies can change at any time. It only takes just one bad policy to have your investment go down the drain. In some of the emerging economies, the government tightly regulates the exchange rates and can decide to bring down the exchange rate at any time. Hostile policies can be on anything — it could also be outrageous taxes on foreign investments.
Lack of liquidity
There is also the problem of liquidity. Generally, the liquidity in the equity markets of the emerging economies cannot be compared to that in equity markets in developed economies. As a result, there is often more volatility in those markets, which can affect the investors negatively. For example, if an investor tries to sell stocks in an illiquid market, there is a high chance that their orders will not be filled at the current price. The transactions will likely go through at an unfavorable level, exposing the investor to a potential loss.
Higher trading cost
As a result of the lack of liquidity in those markets and the resultant volatility, the ask-bid spread could be very high, increasing your trading cost. Besides, the broker may charge higher commissions as they would find it harder to get your orders filled.
Poor corporate governance and higher chances of bankruptcy
Emerging markets are often known to have weak corporate governance systems, with the management, or even the government, having a greater voice on how the firm is run than the shareholders. But we know that a solid corporate governance structure within any organization is very important in making positive stock returns.
Also, there are often restrictions on corporate takeovers, which can make the management less effective as they don’t have to fight for their jobs. The poor governance structure, coupled with weaker accounting systems, may put these companies at a higher risk of bankruptcy.
Unlike in developed nations that tend to follow a free market discipline with minimal government intervention, in emerging markets, the governments and businesses often cross paths. And there are things like subsidies, multiple taxations, policy reversals, and so on.
There are also higher cases of industrial actions, with workers leaving their jobs or even stealing resources. There is also a high risk of civil unrest, which may degenerate into a full-blown civil war.
What you should know about the Chinese stock market
Now, let’s take a look at the Chinese equity market. China’s stock market is often called the Shanghai Stock Exchange (SSE), but the SSE is not the only major stock exchange in China. It is not even the only one in mainland China, let alone the whole of China, including Hong Kong.
The Chinese stock market consists of three major stock exchanges:
- The Shanghai Stock Exchange (SSE)
- The Shenzhen Stock Exchange (SZSE)
- The Hong Kong Stock Exchange (HKG)
The Shanghai Stock Exchange (SSE)
The SSE, just like the SZSE, is located in mainland China, and as the name implies, it is located in the commercial city of Shanghai. The SSE is the largest and oldest stock exchange in mainland China and the 4th largest stock exchange in the world by market capitalization. It is run under the supervision of the China Securities Regulatory Commission (CSRC). The SSE dates back to the 1860s, but it was closed in 1949 when the Communists took power. The exchange was only reopened in 1990 after China started opening up its economy.
On the SSE, for every listed company traded on the exchange, there are two main classes of stock: the A-shares and the B-shares. While the B-shares are quoted in U.S. dollars and are generally open to foreign investment, the A-shares are quoted in yuan and are only available to foreign investment through a qualified program known as QFII.
The Shenzhen Stock Exchange (SZSE)
The Shenzhen Stock Exchange (SZSE) was established on December 1, 1990, and it is located in Shenzhen, a city in southeastern China. Although it is only about 30 years old, the SZSE is the world’s eighth-largest stock exchange by market capitalization. The products trading on the SZSE include the A-shares, B-shares, indices, mutual funds, fixed income products, and diversified derivative financial products. As on the SSE, foreigners can trade the B-shares, but can only trade the A-shares via the QFII program.
The QFII, acronym for the Qualified Foreign Institutional Investor, is a program that allows specified licensed international investors to invest in stocks listed on the stock exchanges on mainland China. The program was introduced by the People’s Republic of China in 2002 to provide foreign institutional investors with the right to trade on stock exchanges in Shanghai and Shenzhen. Prior to the establishment of the QFII program, investors from other nations were not allowed to buy or sell stocks on Chinese exchanges because of the way the country tightly controls capital flows.
The Hong Kong Stock Exchange (HKG)
The Hong Kong Stock Exchange (HKG) was founded in 1891, but it first started listing the largest Chinese state-owned enterprises in the mid-1990s as Hong Kong operates as a politically autonomous region from mainland China. The mainland Chinese companies are listed as H-shares and can be traded by foreign investors. All shares trading on the Hong Kong Stock Exchange are denominated in Hong Kong dollars (HKD).
Is it wise to invest in China?
Yes, maybe. But the answer is not that straightforward. It all depends on your situation and what you want to achieve. Being one of the largest economies in the world, China is home to some of the biggest companies in Asia, and these are some of them:
- Alibaba (Conglomerate)
- Tencent (Conglomerate)
- Industrial and Commercial Bank of China (Banking)
- Ping An Insurance (Insurance)
- China Construction Bank (Banking)
- Agricultural Bank of China (Banking)
- Kweichow Moutai (Beverage)
- PetroChina (Oil & gas)
- Bank of China (Commercial Banking)
- China Merchants Bank (Commercial Banking)
Interestingly, most of those companies have demonstrated the capacity for growth and are still growing. And it’s not just these ones; there are thousands of good companies with growth potential in China. It, therefore, makes sense to want to invest in any of those companies, which are already popular among local investors.
So, if you’re looking to diversify your investments, it may be wise to invest in foreign stocks, and China can be a good place to look for value and growth — there is a wide range of Chinese companies to choose from. But it is not just about long-term investing; the Chinese stock markets have developed enough for short-term swing trading too. Short-term swing traders who are looking for more instruments to trade can benefit from the many stocks listed on the various Chinese stock exchanges.
One good thing about China’s stock markets is the deep liquidity they have. China’s huge population and rapidly growing economy are creating a great number of potential investors that makes their stock markets to thrive. With many potential investors, the stock markets tend to have good liquidity that makes it easy to get in and out of the market, so the issue of looking for a counterparty in trade is minimized.
However, the government still has interests and controls a lot of companies in mainland China. The shareholders, especially the foreign ones, may not be allowed to have much influence on how the companies are run. Also, the Chinese government has always been alleged to manipulate the Yuan, which can affect an investor’s return when converting his funds to USD.
How to invest in Chinese stocks
As a foreigner, you can invest in Chinese stocks, even Tencent Holding. Yes, you can buy Tencent stock from anywhere you are, and there are many ways to do that. However, the three most common ways to invest in Chinese stocks include the following:
- Depository receipts
- Mutual funds or exchange-traded funds
- Online discount brokers
Some Chinese companies are listed on stock exchanges in other countries. For example, many of them are listed on the NASDAQ and New York Stock Exchange in the US and the London Stock Exchange in the UK. In fact, there are 156 Chinese companies listed on U.S. exchanges as of February 2019, according to the U.S.-China Economic and Security Review Commission. Some of the companies include:
- Alibaba Group Holdings (BABA)
- China Automotive Systems (CAAS)
- Acorn International, Inc (ATV)
- Weibo Corporation (WB)
- Concord Medical Services Holdings Limited (CCM)
If you are a resident of any of the countries where Chinese stocks are listed on the stock exchanges, you can trade the stocks via your local brokers.
Mutual funds or exchange-traded funds
Another way you can invest in Chinese stocks is to buy mutual funds or exchange-traded funds (ETFs) that track the Chinese stock markets. One good thing about buying a mutual fund or an ETF is that it automatically offers you a diversified portfolio, and in this case, you are getting exposed to foreign companies. So, in diversifying into a foreign market, you are also spreading out your risk across hundreds or even thousands of companies.
Another benefit of buying a fund is that they don’t have to be actively managed, so they tend to be cheaper than building a portfolio of foreign stocks. If you are considering this option, look for funds that track Chinese equity indices, such as these:
- The Shanghai Stock Exchange Composite Index, which tracks the performance of all A-shares and B-shares on the Shanghai Stock Exchange
- The Shanghai Shenzhen CSI 300 Index, which is made up of 300 A-share stocks on the Shanghai or Shenzhen exchanges
- The Shenzhen Composite Index, which tracks the performance of all A-shares and B-shares on the Shenzhen Stock Exchange
Buying the A-shares, B-shares, and H-shares via an online trans-border discount broker
One easy way to buy the shares of Chinese stocks that are listed on the Chinese stock exchanges is to register with any of the trans-border online discount brokers that is licensed to trade on those exchanges. For example, you can buy Chinese stocks on Robinhood, and you can also buy Chinese stocks on TD Ameritrade.
Apart from those two, other online discount brokers through which you can buy Chinese stocks include Ally Invest, Interactive Brokers, and E*TRADE. With any of those brokers, you can buy Tencent stock or any other Chinese stock you want to add to your portfolio.
Trading futures in a foreign country
The futures market is where participants can buy and sell contracts for the delivery of an underlying asset on a specified future date. The underlying asset can be a commodity or a financial asset, such as individual stocks or an equity index, while delivery can also be by financial settlement, especially when the asset is a financial product.
While it is easier for residents and citizens to participate in their domestic futures market, one can also trade futures in a foreign country if the country’s laws allow foreigners to participate in its futures market.
Can foreigners trade futures in China?
Yes, foreigners can trade futures in China. Initially, foreign companies have to partner with local Chinese companies to operate in the futures exchanges, but China is in the process of granting foreign investors greater market access by removing the ownership restriction on futures companies so that foreign companies can have full control of their business entities.
The China Securities Regulatory Commission is expected to issue a revised regulation soon on qualified foreign institutional investors, which will substantially expand their investment scope and allow them to trade in the derivatives market including financial and commodity futures and options.
Can Chinese citizens trade U.S. futures?
Yes, Chinese citizens can trade U.S. futures because the US allows non-citizens, including the Chinese, to participate in their financial markets after proper documentation. The issue is not about whether the US allows the Chinese to trade but whether the Chinese allow their citizens to easily move funds out of mainland China to trade in foreign markets. It all depends on the capital involved.
If a Chinese wants to wire millions of RMB out of China into a foreign account, they may be required to show documentation verifying the reason for that. In the case of foreign investment, they may be required to seek SAFE approval.
China has transformed its economy to a great extent over the last three decades, opening it up to foreign investors. Foreigners can participate in the Chinese financial markets, including the equity and futures markets, and Chinese citizens can also invest in foreign countries after getting SAFE approval.