China announced a long-anticipated liberali-zation over last week, allowing qualified insurance companies to invest their growing foreign exchange assets in overseas financial markets.

The move was widely lauded as a welcome effort by the government in broadening tightly-regulated investment scope for domestic insurers, although some analysts believe it is paving the way for the qualified domestic institutional investor (QDII) scheme, a landmark liberalization reform planned to help the domestic economy integrate with international markets while capital controls are maintained.

The China Insurance Regulatory Commission (CIRC) and People's Bank of China (PBOC), the central bank, jointly promulgated a provisional regulation last Wednesday, throwing open gates to overseas bond and money markets for qualified domestic insurers.

Some 10 insurers, out of nearly 70 Chinese, foreign or joint-venture underwriters operating in the nation, are currently qualified for investing overseas, CIRC officials said.

According to the new regulation, insurers must have at least 5 billion yuan (US$600 million) in total assets and US$15 million in forex-denominated funds. The qualified ones hold some US$7.5 billion in forex assets, the lion's share of the nation's US$9.8 billion total of forex insurance funds.

That means as much as US$6 billion will be allowed into overseas markets, given a requirement that insurers can invest no more than 80 per cent of their forex assets overseas, said Zeng Yujin, deputy director general of the CIRC's Insurance Fund Management Regulatory Department.

Prelude to QDII?

"This was the right prelude to QDII," said Xu Hongyuan, a senior analyst with the State Information Centre, an influential think tank. "When a formal (QDII) regulation remains unavailable, the insurance sector is opened up as an experiment since it has little impact on domestic stock markets."

Senior forex regulators said earlier that technical preparations for the QDII scheme, which will allow domestic capital into overseas markets under China's still strict forex management regime, were long ready, and expressed hopes that the crucial scheme be approved by the State Council, or the cabinet, by the end of this year.

"That prospect looks uncertain now," Xu said. "Because the domestic stock markets are not doing well."

China's stock markets are still struggling to recover from months-old sluggishness, while macroeconomic uncertainties resulting from the State's efforts to cool down expansive economic growth keep weighing on already weak market sentiment.

"Although the QDII does not affect fund flows in the stock market, it has huge a psychological impact as it symbolizes an acceleration of the expected integration of mainland markets with the Hong Kong stock market, where prices are much lower," Xu said.

Price to earnings ratios on the mainland's fledgling bourses are long seen as unreasonably high relative to mature markets like Hong Kong.

A key reason to allow forex insurance funds to be invested overseas now, the analyst said, was the urgent need to stop as much forex as possible from flowing into China, which will help alleviate pressure on the nation's monetary authorities to maintain appropriate monetary growth.

"If this part of forex flows back home, it will again increase base money through (the central bank's) forex purchases," he said, adding that some of the domestic insurers' forex funds, most likely those raised in recent overseas stock offerings by domestic insurers, are still being held overseas.

The PBOC has been struggling hard this year to balance between enforcing a narrow range for the exchange rate of the local currency, or renminbi by buying excess US dollars in the market with more local currency being released and curbing rapid monetary and credit growth that has prompted worries about the economy being over heated.

Speculation that China may have to revalue the renminbi, which some trading partners complain about as being undervalued, remains unabated this year, which has greatly amplified capital inflows and exerted upward pressure on the renminbi's exchange rate.

But government officials largely denied direct connections between last week's move and the QDII scheme.

"In QDII, clients' funds are pooled before they are invested overseas, but the insurance companies are only dealing with their own money," said an official with the State Administration of Foreign Exchange (SAFE), who declined to be named.

The official's remarks were echoed by CIRC's Zeng. "This (allowing insurers to invest overseas) does not involve pooling money together and converting currencies, so it should not be connected with QDII," he said.

"The money we are talking about here is separated from renminbi funds (in the domestic stock market), and the renminbi is not fully convertible under the capital account," Zeng said. "So it will not have any impact on domestic stock markets."

Two leading domestic insurers China Life Insurance and Ping An Insurance have reportedly expressed their intentions to apply for a QDII licence once the scheme is unveiled.

Broadened investment scope

The unquestioned significance of the policy loosening is that it significantly widened the investment scope for domestic insurers.

"This is really something we would love to see," said Xie Yiqun, chairman of Taiping Life Insurance Co Ltd. "We've long been looking forward to more investment channels to enable higher yields."

Xie said his company has been holding its forex assets, mostly from equity of its foreign shareholders, mainly in bank deposits. "It was OK before, but interest rates have been low recently."

Investments of insurers in China are tightly regulated. They are allowed to invest mostly in deposits and bonds, and can only trade stocks through securities investment funds.

Their investment returns have been shrinking in recent years, as the central bank took a string of interest rate cuts to boost domestic demand and the stock market remained persistently bearish after an unsuccessful reform plan hurt sentiment.

Chinese insurers' average return on investment dipped to 3.14 per cent in 2002 from 4.3 per cent in the previous year, approaching the 3 per cent minimum required by solvency margin regulations. The figure for 2003 was not available.

The situation for their forex funds is presumably worse, as investment channels are even more scarce given the partial convertibility of the renminbi, with bank deposits being almost the only solution.

"We started preparations already," said Xie, whose firm is among the qualified ones. "After we get the official documents, we are going to study the issue further, formulate our own investment strategies, and start."

The investment loosening is particularly good news to the mainland's life insurers, which are losing a growing share of the market to overseas competitors through underground agents.

Insurance firms incorporated in Hong Kong and Macao special administrative regions (SARs), which face almost no investment restrictions, have been grabbing a huge chunk of life insurance business from mainland players in recent years, especially in coastal provinces, by promising higher yields.

The CIRC has been cracking down on the illegal sale of the SARs-based insurers on the mainland, but progress has been slow partly due to demand for high-yield policies.

"When others have the weapon but you don't, it's an unfair battle," Taiping Life's Xie said. "Now we are standing on a closer footing in the competition."

Greater investment freedom will also help the performance of stocks in China's three leading insurers, which were listed in overseas markets, mainly Hong Kong, late last year and earlier this year, analysts say.

Among others, the PICC Property & Casualty, the largest Chinese non-life underwriter which became the first domestic insurer to be listed after an initial public offering in Hong Kong, is forecasting a 3 per cent return on investment (ROI) for this year, compared to 1.7 per cent last year.

Analysts have said higher ROI depends on the launch of the QDII scheme, and whether premiums can be invested in overseas capital markets, though they believed QDII was unlikely to be given the green light in the near future.

The high asset threshold for overseas investments has, however, frustrated the smaller insurance providers operating in the country.

"So most of the foreign insurers are excluded," a senior manager at a foreign insurer's branch in Guangzhou, Guangdong Province, said after hearing the asset requirements.

The manager had expressed joy immediately after hearing the news, saying his branch had "quite some" forex funds. "We hope to be able to invest like our sibling overseas firms," he said.

Thirty-seven foreign insurers had entered the Chinese market by the end of last year. Their total premiums remain incomparable to domestic players at present, but growth prospects are rosy with all restrictions on them being scheduled to be removed at the end of this year as part of China's World Trade Organization commitments.

The CIRC's Zeng declined to say if any foreign insurer is on the list of qualified players.

Yet analysts say a 5 billion yuan (US$600 million) asset threshold is not too high for life insurers in China, where life insurance premiums have been growing rapidly.

On a related front, Zeng said technical preparations for allowing insurers to directly trade stocks in the domestic market, also a long-anticipated move, were ready.

"Necessary legal procedures are being completed at present," he told reporters on Friday. "Co-ordination with other regulatory agencies is also being promoted actively, and they have given their endorsement."

Custodianship opportunities

The new regulation has excited domestic commercial banks, both Chinese and foreign-funded, by generating fresh custodianship opportunities.

Insurers are required to find a commercial bank operating in China as the custodian to babysit their funds, which will in turn find an overseas partner as a secondary custodian to oversee the funds in foreign markets.

"We are certainly interested, and will apply as soon as possible," said Zhou Yueqiu, head of custodian operations at the Industrial and Commercial Bank of China (ICBC), China's largest commercial bank.

Last week's policy loosening provides a critical opportunity for Chinese commercial banks to expand their fledgling custodian operations to a global basis, Zhou said. "This opens up the channel to overseas custodianship."

Although the custodianship market of insurance forex remains small relative to the domestic custodian market, a global custodianship has huge business potential given the prospect for QDII or similar reforms that will allow domestic funds to be invested overseas, analysts said.

"It is the future trend that Chinese capital will move on into international markets," Zhou said. "And as long as the funds get out (of the country), they need a custodian bank."

Chinese banks are attaching growing significance to the custodian business in recent years, not only for the stable revenues it generates, but because it can help them prepare for the expected integration of the banking, securities and insurance sectors, which are still strictly separated in China.

The ICBC stands as the largest Chinese custodian bank in the domestic market, overseeing 100 billion yuan (US$12 billion), or 29 per cent of all funds under custodianship by Chinese banks. The business is projected to bring the bank more than 100 million yuan (US$12 million) in profits for this year alone, Zhou said.

"The share of the business (in the bank's total profits) is still small, but it's growing very fast," he said, adding his bank's custodian business expanded by an average of 70 per cent in the past six years.

But new opportunities do not simply drop in. "Competition (for custodianship of insurance forex funds) will be fairly tough," Zhou said. "Both Chinese and foreign banks will pay a lot of attention."

Foreign banks have set up some 200 operational entities in the Chinese market, with 100 of them having won licences for local currency business. They are so far leading the race for custodianship of qualified foreign institutional investors (QFII), largely thanks to their ties with foreign institutional investors.

China launched the QFII scheme more than a year ago, which allowed foreign investors to put their money in domestic capital markets. Investment quotas total US$1.9 billion at present.

But it is difficult to predict which will have the upper hand this time. "Both have their own advantages," Zhou said. "Foreign banks are more familiar with overseas capital markets, but Chinese banks have long-standing ties with potential clients, and probably understand the clients' needs better."

Risk management critical

Both officials and insurers highlighted the need to contain risks in investing in overseas markets, which few domestic insurers are familiar with.

CIRC officials said setting the 5 billion yuan (US$600 million) asset requirement was one major attempt to contain risks. And the regulation circumscribes strict restrictions on types of products insurers can trade - mostly bonds with high credit ratings and relatively safe money market instruments. Stocks are forbidden.

"The loosening is welcome, but it poses higher requirements on the risk management of insurance companies," Taiping Life's Xie said. "At Taiping Life, we are going to stick to our strategy of prudence. Asset quality first."

Also to contain risks, the new regulation allows insurers to not only make their own investment decisions, but ask foreign institutional investors to do the job.

The regulation requires such institutional investors to have at least US$60 million in both paid-in capital and net assets, and funds under management to be no less than US$50 billion.

"That is fairly high criteria," the CIRC's Zeng said. "I believe the companies will determine their investment approach on a comprehensive basis."

Zeng would be pleased to hear the plan of Taiping Life's Xie, who said his firm would not only take advantage of the investment expertise of both its foreign shareholders and other subsidiaries of its parent group, but build its own investment team.

Taiping Life is partly owned by Fortis Insurance International NV, a subsidiary of European financial services provider Fortis. Its majority shareholder China Insurance Group also has an asset management company in Hong Kong.

"We certainly are going to use their channels and experience, but we will also train our own staff to try on our own," Xie said.