Monday 03 July 2017

Celebrations marking the 20th anniversary of Hong Kong's handover came with a new channel into China's USD9.4 trillion bond market*.

Bond Connect is the latest step in China's ongoing process to liberalise its financial markets. By creating a new route for international investors to access Chinese onshore fixed income products, the scheme is likely to increase foreign participation in the local bond market.
Foreign holdings of Chinese bonds are currently just 2% of the total market, but we expect continued improvements in onshore market access to attract more offshore investors, bringing the level of overseas ownership closer to international norms.
There is clearly demand among global capital to invest in Chinese debt. Foreign holdings of Chinese bonds rose for the third straight month to RMB 775 billion in May, according to the latest data from China Central Depository & Clearing Co.
Part of this is due to the attractive yields that are available onshore. There is also a realisation that China is a market that is too big to ignore – something that was highlighted by MSCI's long-awaited decision in June to include A-shares into its benchmark emerging markets index.

"Over the last year China has been normalizing policy. We've seen the currency stabilize and bond yields start to become more attractive"
CG Lai - BNP Paribas Head of Global Markets for China

"But the MSCI's decision to include Chinese A shares has prompted heightened expectations – that we've never seen before – and really demonstrates that the world needs to recognize and embrace the Chinese market," he said. "It's only a matter of time before we see bonds also included in international indices."
Bond Connect complements a number of pre-existing routes into mainland China's financial markets. The oldest channel is the Qualified Foreign Institutional Investor program (more commonly known as QFII), and its renminbi equivalent RQFII. Last year, the Direct China Interbank Bond Market (CIBM) program was widened to grant a broader range of foreign institutional investors' access to the onshore interbank bond market.
The latest program differs from the earlier channels by allowing investors to conduct trading and settlement via a single offshore platform. In this respect, it follows the successful Stock Connect program, which create similar links between Hong Kong and the mainland's stock exchanges in Shanghai and Shenzhen.
The result is a system that is both more efficient in terms of both cost and time, due to a simplified application procedure, less documentation requirements, and a shorter turnaround when compared with the alternatives.

That said, Bond Connect is limited in the range of instruments that can be traded, as it only applies to cash bonds – such as central and local government bonds, commercial bank bonds, and enterprise bonds. Investors using CIBM can take advantage of more onshore risk management tools, such as interest rates swaps, and funding instruments like repos. The restricted scope of Bond Connect could hold back the initial uptake for the scheme.
""When we see clarification of primary subscription operational details, as well as product expansion into risk management and funding we think there will be a significant boost in trading volumes ""
Bond Connect departs from the Shanghai and Shenzhen Connect programs in that there is only a northbound route into China – in other words, it creates a link for foreign investors from Hong Kong to Mainland China with no quota restrictions. It will launch with no Southbound route for Chinese investors that want to allocate capital to offshore bonds, though we expect the scheme to be expanded at a later stage.
The long-term influence of increased foreign ownership in onshore bonds will be improved standards in the market, as international investors bring their experience of more developed geographies to bear in China. Since the current level of foreign ownership is negligible, overseas investors have very little influence, but it could grow into an important voice in the market – especially to issuers looking to raise capital. 
"By broadening the investor pool, we believe China should improve the quality of its debt markets, as well as generate cash inflows that will help with Beijing's battle to stem capital outflows"
Furthermore, the launch of Bond Connect opens a route into the onshore fixed income market in a way that cements Hong Kong's status as Greater China's international financial center and offshore RMB hub. The use of Hong Kong's trusted institutions and established infrastructure, leaves us confident that the city will become an important stepping stone into the Chinese bond market.

BNP Paribas is the proud recipient of Asia Risk's RMB House of the Year award in 2017, the second time since 2015 the bank has won this prestigious honour.

*China's USD9.4 trillion bond market, as of September 2016, according to Bank of International Settlements Data.

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