China launches the Bond Connect scheme on 3 July 2017, two weeks after MSCI announced that it would add 222 large cap Chinese domestic stocks to its benchmark Emerging Markets Index. Both events follow the inclusion of the renminbi in the International Monetary Fund's (IMF) Special Drawing Rights (SDR) basket in October 2016. Although their short-term market impact may be small, these developments may prove to be long-term game changers that could boost China’s asset prices over time.
Bond Connect: no quotas
Similar to the Stock Connect scheme, Bond Connect in principle allows foreign investors to trade/invest in the onshore China interbank bond market (CIBM) via Hong Kong (the northbound flows) and mainland investors to trade/invest in Hong Kong bonds (the southbound flows). At this stage only northbound trading has been approved as capital outflows remain a policy concern.
Bond Connect adds to the QFII, RQFII, and CIBM direct-access programmes for foreign investors to access the CIBM. It aims at connecting the onshore and offshore market infrastructure, including the Central Moneymarkets Unit (CMU) of the HK Monetary Authority, the China Central Depository & Clearing Co. (CCDC) and the Shanghai Clearing House (SCH). This should reduce the lead time for foreign investors to invest in China’s onshore bonds because they will not need to open onshore accounts.
Stock Connect is restricted by net-buy quotas, but there are no quotas for Bond Connect. The scheme is initially only available to institutional investors, and only includes cash bonds available in the CIBM, not onshore exchange-traded bonds.
Over the counter trading
While Stock Connect trading occurs via exchanges, Bond Connect trading is over the counter. Foreign investors are exposed to counterparty risk with the CMU, as their onshore Chinese bonds are held under a nominee structure at the CMU. But as the CMU has quasi-sovereign ratings by S&P/Moody’s/Fitch at AAA/Aa2/AA+, which are higher than China’s sovereign ratings, this risk should be negligible.
At this point, block trades are not allowed under Bond Connect. This may pose a hurdle for large investors looking to do one sizable trade for allocation to their various portfolios. Until China’s capital-account rules change, Bond Connect investors will not have access to onshore Foreign Exchange (FX) hedging facilities because without an onshore account, there is no onshore counterparty to deal with in a derivatives trade. But such facilities are open to CIBM direct-access investors as they have to have an onshore account. Hence, Bond Connect only provides access to onshore cash bonds.
If Bond Connect follows the restriction on Stock Connect on using offshore renminbi (or CNH) liquidity only, a successful Bond Connect operation will actually be counterproductive to renminbi internationalisation in the short-term. This is because it will lead to more renminbi flowing back to China and, thus, further erode the CNH pool, ceteris paribus.
Initial bond buying may be modest
From a macroeconomic perspective, Bond Connect is another tool for China to pursue its asymmetric capital account liberalisation (by encouraging capital inflows but not outflows), which will remain the medium-term strategy, in our view. It is more restrictive than the Stock Connect scheme and the CIBM direct-access programme as it is not available to retail investors and provides no access to onshore hedging facilities at this stage.
Initial foreign buying via Bond Connect is expected to be modest, for example less than the RMB 397 billion new inflows into A-shares in the first seven months following the launching of Stock Connect in November 2014 (Securities Daily, November 2016), because:
- Foreign retail investors are not allowed to buy, while many foreign institutional investors have already had exposure to the CIBM and official institutions are already allowed unrestricted investment in the CIBM
- Foreign sentiment on Chinese assets is currently less bullish than when Stock Connect was launched. However, foreign demand may eventually rise after an expected slow start as macroeconomic and regulatory factors are converging to boost Chinese bond prices.
Increased foreign participation via Bond Connect should help improve price discovery in China’s onshore bond market, thus improving its efficiency. Just as Stock Connect supported the inclusion of A-shares in the MSCI Emerging Markets Index, Bond Connect could help speed up the inclusion of Chinese bonds in global bond indices, notably the JPMorgan Global Bond Index, the Bloomberg-Barclays Global Aggregate Index and Citibank’s World Government Bond Index.
Deeper strucural reforms needed
China’s Stock and Bond Connect schemes are signs that the authorities are endeavouring to reform the system within its political and economic constraints. Investor confidence in Stock Connect is rising as it has proven to be subject to less arbitrary interventions. Eventual 100% inclusion of Chinese stocks in MSCI indices would mean inflows of USD 40 billion a year. Bond Connect could well enjoy the same experience. But before achieving this promising state, China will need to overhaul governance and openness, which will need deeper structural reforms.
Written on 03/07/2017
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