Shanghai has started the countdown to the introduction of a "qualified domestic limited partner" (QDLP) scheme, which will allow foreign hedge funds to raise yuan capital on the mainland to make investments in overseas securities.
The city has submitted an application to the country's foreign exchange regulator for a US$5 billion quota, which may then be distributed to funds wishing to participate in the scheme.
Shanghai's move comes as it faces competition from Qianhai, an experimental financial zone in Shenzhen that is being used as a testing ground for freer yuan usage and capital account convertibility.
Government officials said the application for the investment quota was in the final stage of preparatory work for the launch of the scheme, although a launch date had yet to be decided.
An official with the Pudong Financial Services Bureau said: "The QDLP programme will be launched sooner rather than later. The city officials are very active in pushing ahead with major liberalisation, including the QDLP."
Under the QDLP scheme, qualifying foreign hedge funds must be registered with the local authorities before they can convert yuan funds that they will be allowed to raise from mainland high-net-worth individuals into foreign currencies for securities investments abroad.
The scheme, initially proposed by the Shanghai government, is intended to bolster the growth of the domestic hedge fund sector.
Hedge funds that raise capital privately are still in a rudimentary stage on the mainland, and cash-rich Chinese investors have little knowledge about the operations of thesector.
Shanghai hopes to change all that by introducing powerful global institutions such as Winton Capital and Oaktree Capital, to set an example for the mainland hedge fund industry, although it will allow foreign companies only to play in overseas stocks.
The city has made no secret of its ambition to transform itself into a global financial centre, but it is facing competition from Qianhai, an otherwise backwater area in Shenzhen which has risen to prominence since Beijing gave it approval last year for a trial of bold financial reforms.
Bankers and fund managers said Qianhai was more efficient than Shanghai in approving the establishment of new funds and loosening regulations on cross-border capital flow between Shenzhen and Hong Kong.
Senior Shanghai city officials, including the executive vice-mayor, Tu Guangshao, a former vice-chairman of the China Securities Regulatory Commission, are now actively backing more liberalisation of the financial markets to allow freer cross-border capital flows.
The yuan is still not fully convertible under the nation's capital account. Foreign institutions may only buy mainland stocks through the qualified foreign institutional investor programme, while mainland investors may buy into qualified domestic institutional investor products offered by mainland mutual funds and banks to gain indirect access to overseas markets.
The QDLP scheme, designed for foreign hedge funds, complements the qualified foreign limited partner system Shanghai launched in 2011.
The domestic limited partner scheme enables domestic capital outflows into foreign securities, whereas the foreign limited partner scheme enables foreign capital inflows into domestic assets.
In 2011, Shanghai obtained a US$3 billion quota to run a pilot version of the QFLP scheme, allowing select foreign investors to convert capital raised outside the mainland into yuan before investing in yuan-denominated private equity and venture capital funds.
Sources said Shanghai might now get a US$3 billion initial quota for the QDLP scheme, rather than the US$5 billion it had bid for in its discussions with the State Administration of Foreign Exchange.
Howhow Zhang, the chief researcher at Z-Ben Advisors in Shanghai, said: "It doesn't look as if foreign hedge funds would find it easy to raise capital domestically, since mainlanders are still not very interested in their products."