Chinese Financial Market Liberalisation Could Soon Let In Hedge Funds

by Phillip Morton, Investors Offshore.com

17 January 2006

The latest phase of China's financial market liberalisation will see the creation of a new derivatives exchange and could result in hedge funds becoming an established feature of the country's investment landscape in the near future, according to reports.

Senior sources from inside China's securities industry revealed in a report published by the Sydney Morning Herald on Monday that plans are afoot for a new exchange, likely to be based in Shanghai, where instruments such as stock index futures, interest rate futures, and foreign exchange futures would be traded.

China currently has three commodities futures exchanges based in Shanghai, Dalian and Zhengzhou, but until recently derivatives trading was banned by the authorities as the result of a stock market scandal in 1995.

The establishment of derivatives market where institutional investors can hedge their exposure to the financial markets would mark a significant milestone in the development of China's capital markets and would be a natural progression following the approval of an important amendment to China's securities law by lawmakers in October which now allows firms to trade financial derivatives.

The amended law, which is effective from January 1, permits state enterprises to buy and sell shares in China's 1,400 listed firms. The new regulations also give the State Council power to allow some firms to offer a mixture of banking, insurance and securities services.

The authorities ushered in the new law in an attempt to fuel the development of China's capital markets whilst protecting the interests of investors. Since 1995, companies and financial institutions had been prevented from hedging risk, a factor which has acted as a barrier to the growth of securities markets.

The emergence of derivatives markets in financial instruments in China could also result in hedge funds making deeper inroads into China, despite the government's past reluctance to embrace these loosely regulated investment vehicles for fear of promoting more volatility in the markets.

Hedge funds are currently forbidden by the Chinese authorities, reflecting the government's view that they were partly responsible for the Asian Financial Crisis in the late 1990s.

However, according to Jeffrey H Tucker, founding partner of the Fairfield Greenwich Group (FGG), a leading developer and investor in hedge funds, it is only "a matter of time" before hedge fund investing becomes commonplace in China, and he predicts that development of a hedge fund industry will accelerate over the next three years.

"Having discussed with the Chinese authorities, I believe that the consensus already seems to be developing that it is only a matter of time before hedge fund investing becomes a reality in China," he was quoted as saying by China Daily.

Mr Tucker has been touring areas of China in an attempt to educate government officials on the merits of hedge funds, and explode the "misconceptions" that hedge funds are always highly leveraged and contribute to market volatility

Mr Tucker says that only 2% of hedge funds use leverage of more than 5 to 1.

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