Liquidity into stock markets is poised to flow in from an unlikely source: China. The Chinese authorities have recently allowed retail investors to invest in overseas stocks through QDIIs or qualified domestic institutional investors, which will float mutual funds for the purpose. The move is a government initiative to entice domestic investors away from the overheated Chinese stock markets.

The plan had initially met with scepticism, on the very plausible grounds that Chinese investors would prefer the astronomical returns earned so far from investing in their own markets rather than venture into uncharted territory.

But look what happened when the first QDII offer was launched earlier this week by Shenzhen-based China Southern Fund Management. The fund had got permission to raise $2 billion (Rs8,100 crore) and it was supposed to be open for subscription from 12 September to 28 September. But the target amount was raised within an hour of the fund’s opening and the sale window was closed after the very first day, after raising a huge $7 billion. So much for the theory that the Chinese don’t want to invest overseas.

The fund’s corpus will be invested in 10 markets. These include the developed markets of the US, Japan, Hong Kong, Switzerland and Italy, as well as the emerging markets of Russia, Brazil, Malaysia, Korea and, hold your breath, India. We could soon see the first Chinese funds flowing into our markets. More importantly, if the first such fund could attract such a huge amount of money on the very first day, think of the amount of money waiting to be invested overseas. Banks in China offer a pathetic rate of interest, well below the inflation rate, and that has driven up the prices of Chinese stocks and real estate as investors seek alternative avenues for higher returns.

But, like investors in the rest of the world and like their own government, Chinese investors too must be worried that their markets are getting overheated. The solution: diversification into other markets.

What impact this will have on other markets can only be imagined. The Chinese are prodigious savers and they are estimated to have $2.3 trillion stashed away in low-yielding bank accounts. If even a fraction of that money finds its way overseas, it could drive markets up. As a matter of fact, that’s what has already happened to the Hong Kong stock market, which has gone up in anticipation that a new rule will allow individual investors on the mainland to invest in the Hong Kong market. A massive shift towards investing inequities is under way in China and 35,000 brokerage accounts are opened every trading day, with the total number of broking accounts reported to have crossed 100 million.

Add to that the fact that China Investment Co., the sovereign wealth fund created to get a higher return on the country’s trillion-dollar-plus forex reserves, will be operational soon. That’s sure to deploy a part of its massive corpus in stocks.

China’s securities watchdog is also considering lowering the threshold for individuals allowed to invest in banks’ QDII products to 100,000 yuan (US$13,158), according to China Securities Journal, from the current level of 300,000 yuan. That should help QDIIs raise even more funds. Sure, the money is not going to flow out overnight, but the phenomenal success of the first QDII offering certainly shows that we’re going to see more and more Chinese money in our markets.

The next bubble?

The outflow of funds from China to the rest of the world was also touched upon in a recent speech by US Federal Reserve chairman Ben Bernanke, who pointed out that “emerging market countries and oil producers remain large net suppliers of financial capital to global markets." In other words, in spite of the current credit crunch in the rich countries, the supply of liquidity to the markets is unlikely to be affected. The question is: where will the liquidity go? JPMorgan’s Asia Pacific and emerging markets strategist Adrian Mowat was in Mumbai recently, talking about the increasing disconnect between the equity and credit markets. Equities continue to soar blithely, unhampered by the toll in the credit markets. Mowat is firmly in the camp which believes that the true extent of the carnage in the credit markets and its implications hasn’t fully registered in the minds of equity investors. As proof, he points out that, according to the 2006 US flow of funds data, asset-backed securities (ABS) financed one third of all private borrowing in the US, and the ABS market is one of the worst affected by the current crisis. The point he was trying to emphasize was that the financial sector problems would spill over to the real sector in the US.

What about the Indian market? JPMorgan’s rather bearish view on India is well-known, but Mowat had an interesting twist. In 1998, when the Fed cut rates after the Asian crisis and the Russian default, all the liquidity went into US stocks, driving the Nasdaq to stratospheric levels. It may well happen that the extra liquidity provided by the Fed may spill over into emerging markets this time, driving up stocks here. Note that, while spreads on high-risk bonds have gone up substantially, the impact on emerging market bonds hasn’t been much. That’s because, increasingly, investors are recognizing the potential for growth in emerging markets. Of course, the falling dollar also helps. Emerging markets could well be the next bubble.

Mint’s resident market expert Manas Chakravarty looks at trends and issues related to investing in general and Indian bourses in particular. Your comments are welcome at