Last month, mainland China’s protracted move into short-selling finally became reality. In a statement published on the China Securities Regulatory Commission (CSRC) website, the Chinese regulator announced that the practice of borrowing and selling Chinese stock was to be officially permitted on its two onshore stock exchanges sometime in the near future. And not just short-selling – margin trading and futures were also given the governmental seal of approval.

On the face of it, the announcement should have Asia-focused hedge funds on tenterhooks. Widely considered the fastest growing economy on the planet, China’s leading onshore exchange, Shanghai, now rivals the LSE in terms of capitalisation. According to the World Federation of Exchanges, Shanghai is the world’s sixth most-capitalised exchange, with $2.7trn. China’s second onshore exchange, Shenzhen, was last year’s best-performing, up around 145% in USD (after a high-profile slump in 2008). Hedge Fund Research’s (HFR) China index, meanwhile, last week posted a record performance gain of 50.4% for 2009.

Managers, it seems, are voting with their feet. A number of hedge funds, including Marshall Wace, have established new or improved Asian hubs in recent months, while just last week, star money manager Anthony Bolton – who dabbled in short-selling during a high-profile stint in charge of the Fidelity Special Situations fund – confirmed April as the launch date of his highly anticipated Fidelity China Special Situations, which will pump £630m ($982m) into Chinese stock. "I firmly believe that China is the investment opportunity of the next decade," Bolton said, when revealing his plans last November.

“We are seeing more and more managers in China with a credible short side,” says Chris Keen, partner at fund of hedge funds (FoHF) Culross Capital Management, a firm that has recently increased its exposure to China/ex-Japan. “We see this announcement as further evidence of the maturing of the financial markets in Greater China.”

Not everyone is convinced by China’s potential – James Chanos, founder of US hedge fund Kynikos Associates, has famously said the country’s credit excesses looked “like Dubai times 1,000 or worse” – but for those foreign managers who are, and who wish to take advantage of the country’s new toolbox, a convoluted path lies ahead. Large parts of China’s mainland market are still off limits to non-Chinese residents, and, according to Asia-focused analysts, foreigners keen to short will have to wait their turn.  

“It is likely that short-selling will be eked out first for domestic rather than foreign investor consumption and then on a stock-by-stock pilot basis,” says Mark Smith, an analyst with Northwest Investment Management China Opportunities (Nimco).

Fellow Asia analyst David Walter, a Singapore-based associate director with $9bn FoHF Paamco, believes the news “potentially” heralds the birth of a genuine Chinese hedge fund industry. “Short-selling will encourage more domestic Chinese hedge funds,” he says.

The CRSC’s short-selling experiment – under consideration for a number of years – began with a trial in late 2008, having been delayed by the Beijing Olympics. The 2008/09 trial, though ultimately successful, was limited to 11 hand-picked brokerage firms. For the 2010 pilot, rumours suggest six or seven firms will get the nod. Smith estimates that margin trading and securities lending will commence as early as March/April, followed by futures trading in May/June.

As is typical of the People’s Republic of China (PRC), details have been sketchy. Expectations are that information will continue to emerge at a trickle, with the programme implemented on a prolonged, step-by-step basis.

One regional prime broker, who welcomed developments but declined to be named, told HFMWeek that, if China is serious about defining its hedge fund universe, a more solid prime brokerage framework – most likely along the lines of Japan’s “slimmed-down”, domestic offering, will be on the cards.   

Whatever the next stage, China’s aim appears well-defined, says Smith. The goal is to open up the tools available for China to continue to finance a GDP growth of close to 10% per annum – tools that, until now, have appeared somewhat blunt. “The introduction of short-selling and futures is an expected, but nonetheless significant event,” he says, “certainly with respect to the domestic A-share market, where the concept of a true hedge fund was something of an oxymoron.”

There are two onshore share classes in the PRC: local currency A-shares and foreign currency B-shares. The A-class – a much larger and more attractive market than its B-class counterpart – is designed for Chinese residents, with only a handful of Qualified Foreign Institutional Investors (QFII) allowed to trade in them (QFII holders receive an investment quota of up to $1bn, recently increased from $800m).

In the past, the few China-based hedging opportunities that existed centred on the relationship between A-shares and H-shares (shares listed in offshore Hong Kong, where shorting has long been possible). One route would be to go long in A-shares and short in H-shares. A second would be to play an arbitrage on the spread, with the more lucrative A-shares typically trading at a premium.  
 
HFMWeek’s unnamed prime broker suggests that the long A/short H technique is “not dynamic” enough to warrant true hedge fund status. On the flip side, some commentators have argued that, with the shorting of A-shares possible, the arbitrage strategy will lose its appeal as price gaps diminish.

According to Smith, most China-focused hedge funds are predominantly beta players. Though the PRC’s GDP may be seen as a selling point, history, he says, has shown that strong GDP growth does not translate into strong equity returns.

“Pre-announcement, the domestic China market represented partly a macro bet for the majority of hedge funds,” Smith explains. “Post-announcement it opens up a significant market, which sometimes trades a similar USD volume to the US market, for true hedge fund participation.”

The potential for China’s first “true” domestic hedge funds may excite Chinese investors, but Paamco’s Walter remains wary of further developments. “I suspect the CSRC will come out with some more serious regulations on how short-selling is going to work, who’s allowed to do it and how it’s going to be policed,” he says, echoing the cautious optimism of all HFMWeek’s interviewees.
More immediate regulatory developments are already reducing the options open to foreign hedge funds. As China’s potentially lucrative onshore A-share market is only accessible to holders of a QFII licence (requirements include a minimum of $5bn in capital and a long track record of profitability), access for non-holders requires a relationship with an entity with QFII status. Common routes have been via QFII-holder access products, such as Participatory Notes (‘P-notes’ mirror the performance of underlying stock), or by renting the QFII structure, allowing the renter to use part of licensee’s $1bn investment quota.   

“From our conversations with Beijing, it's not QFII rental to hedge funds but access products which are fine in the eyes of regulators,” Smith says. Last November, Swiss bank UBS – the first and largest institution to gain QFII status – terminated its renting facility, after interpreting new regulations from Beijing as a ban on the “transfer or sale” of QFII quotas.

Chris Ruffle, co-chairman of MC China, a subsidiary of Martin Currie Investment Management and a QFII renter, told the FT last month that UBS had moved his fund into P-notes, which are considered more complicated to trade and seen as carrying greater credit risk. HSBC went further, shutting its QFII facility and withdrawing access via P-notes.
Whether a result of regulatory pressure or otherwise, the access product is today’s route of choice, says Smith. “I imagine few if any hedge funds 'rent' QFII. They use access products like we do.”

China’s reputation for red tape and restrictions is, of course, almost as well-documented as its reputation for potential growth. Last month, emerging markets specialist GFIA, whose China-dedicated hedge funds peaked at about $3m (10% of its portfolio), reported plans to halt coverage of China, citing the region’s ongoing lack of transparency.
Peter Douglas, GFIA’s principal, told HFMWeek that the firm had decided that the fiduciary risk of investing in PRC-run hedge funds is too high. “We’ve been concerned about transparency, attitude to investors and business ethics, since we started researching mainland Chinese boutiques in 2004,” he says. “We’ve expected it to get better, but it hasn’t.”

Nonetheless, Douglas welcomes January’s announcement and the avenues it will open. “It’s important as it will add significant liquidity to the market. Previously, establishing hedging positions for a PRC portfolio was difficult and inaccurate, the new proposals should facilitate more sophisticated portfolio management and this should create opportunities for hedge fund managers.

“It will allow more relative value, lower volatility strategies than the currently predominantly long-biased model, or unconstrained long approaches,” Douglas adds. “I expect to see growth in new strategies post announcement – a mix of new boutiques and established managers adding new strategies.”

China’s short-selling announcement has been met with universal commendation, but the lack of specifics has infused optimism with a quiet sense of caution. That said, though the threat of increased regulation looms, and detail may be noticeable by its absence, one element of certainty remains – in one form or another, 2010 has seen a significant step towards a true Chinese hedge fund industry. The great wall may prove difficult to scale, but non-resident hedge fund managers have been given the first real sign that they are welcome to try.