OVERSEAS appetite for China's yuan-denominated Class A shares has recovered as equity markets rose after a three-year decline and regulators stepped up moves to make the country's capital markets more friendly to foreign investors.

Participants in the Qualified Foreign Institutional Investor (QFII) program opened 104 accounts to trade A shares from January to November this year, up sharply from just 24 entries for 2011, according to the China Securities Depository and Clearing Corporation.

On December 14, in the latest relaxation of rules on foreign investment, the State Administration of Foreign Exchange abolished the US$1 billion ceiling for sovereign wealth funds, central banks and foreign monetary authorities participating in QFII. No new upper limit was specified.

Launched in 2002, QFII is a main gateway for foreign institutions to access China's yuan-denominated markets. In the past decade, the program has witnessed a more than 10-fold expansion in both the number of participants and the size of approved investment quotas.

The long slump in China's stock market cooled that ardor. QFII funds that invest solely in China's A shares lost 10.4 percent on average in 2010, 25.3 percent in 2011 and 9.1 percent in the first 11 months of this year, according to Lipper, a subsidiary of Thomson Reuters.

"The size of some QFII funds has shrunk considerably in the past three years due to losses and redemptions by investors frustrated by the funds' poor performance," said Xav Feng, head of Lipper's research in the Asia region.

Sentiment seems to be changing amid perceptions that the Chinese stock market, at near historic low valuations, has hit bottom.

China market more attractive

"QFII fund managers have begun to stir since the Shanghai Composite Index fell to the 2,000 level," Feng said.

The valuation of Shanghai's stock market on December 3 declined to its lowest level since 1997, with the price-to-earnings ratio of the index at 10.8 times, according to data compiled by Bloomberg News. That makes the Chinese stock market more attractive, especially while developed markets remain inhibited by the "fiscal cliff" political showdown in the US and the debt crisis in the eurozone.

"I think now is a good time to invest in the Chinese stock market because the current valuation indicates considerable returns in the future," said Tomas Franzen, chief investment strategist at the Second Swedish National Pension Fund, which received approval to become a QFII participant in September.

Investment sentiment in China has been further buoyed by the stock market's recent rebound. Between December 3 and December 14, the Shanghai Composite Index has surged above 10 percent from a near four-year low.

"We increased our onshore exposure at the end of July in order to take advantage of the QFII available because I think we will see a new rush amongst foreign investors when the market picks up," Christina Chung, head of Allianz Global Investors' China team in Hong Kong, said in an interview with Citywire Global.

Upbeat over market

Market watchers and investors are upbeat the market's current positive performance will continue into the new year as China's economy gathers pace after seven quarters of slower growth.

Goldman Sachs is forecasting that the Shanghai Shenzhen CSI 300 Index, a gauge of the performance of 300 stocks traded on the Shanghai and Shenzhen exchanges, will advance 26 percent next year. The investment bank recommended that overseas investors increase their holdings of A shares.

"An increase of 20-25 percent is hardly aggressive compared with other stock markets," said Lipper's Feng. "But if that happens, it will signal the end of a bear market, and it's not impossible that China's market may replicate its 2006-2007 performance, when the Shanghai Composite Index surged from about 1,000 points to a record 6,124."

Regulators are hoping to stoke a new era for the market by coaxing more foreign money into the country.

In April, the aggregate cap on money foreigners were allowed to invest in domestic capital markets was increased to US$80 billion from US$30 billion.

In July, the China Securities Regulatory Commission relaxed controls over QFIIs, allowing participating funds to hold stakes of up to 30 percent in a listed company, up from 20 percent previously.

Guo Shuqing, head of the CSRC, said last month that China will further increase the quota if the US$80 billion gets used up quickly.

China is also speeding up the approval process for QFII applicants. It issued QFII licenses to 66 foreign companies in the first 11 month of this year. It issued 29 for the whole of 2011 and 13 in 2010, according to the CSRC.

Between January and November, China's foreign-exchange regulator, the State Administration of Foreign Exchange, granted quotas totaling US$14.4 billion to foreign institutions. In the 2008-11 period, SAFE granted an average annual US$2.6 billion, according to Z-Ben Advisors, a research and consulting firm.

Furthermore, China's ambitions to promote the yuan as an international reserve currency and establish Shanghai as a global financial center point to wider opening of the investment space, Z-Ben Advisors said.

Foreign money accounts for only 1 percent of the market capitalization of the Shanghai and Shenzhen exchanges, and that percentage would rise only marginally even if the whole US$80 billion quota were used up, the advisory firm added.

By contrast, foreign investment accounts for 22 percent of stock market capitalization in Malaysia and 36 percent in the Korean market.

"Clearly, if China is serious about cementing its role internationally and in promoting the use of its currency abroad, then the current US$80 billion figure may just be a drop in the (ocean)," said Francois Guilloux, a director at Z-Ben Advisors. "It stands to reason that regulators will be even more aggressive in 2013 than they were in 2012."

Caps and limits are only one hurdle to a more open market. Other potential deterrents built into the regulatory mechanism and investment operation also need to be addressed.

Restrictions bug

An investment by a QFII investor is subject to rules. For example, a participant has to invest as soon as approval is received, and strict restrictions on stock positions prevail. Then, too, the regulator may reduce or revoke a QFII's quota if the full amount of the quota is not invested within a specified time.

"Such restrictions prevent QFIIs from investing based on market timing," said Li Chen, strategist at UBS Investment Research.

Another question facing QFIIs is the ambiguity of tax policy, according to Cindy Qu, an analyst at Z-Ben Advisors.

Under the current regulations, a QFII participant is exempt from the 5 percent business tax on investment gains but needs to pay a 10 percent corporate income tax on dividends, bonuses and interest income gained in China.

Talk about China imposing a capital gains tax on QFII investors persists, but no proposals have been introduced.

These uncertainties force many QFII investors to set aside funds from their profits for a possible future tax.

The CSRC has pledged to further simplify the QFII application process, ease curbs on fund remittances and setting up accounts, and clarify the QFII tax policy as soon as possible. No timetable has been announced.

"Addressing these issues will be critical if regulators want to stimulate more investment interest in China," said Guilloux, who said he expects action sooner than later.