The Chinese bond market itself is separated into two main markets. On the one hand, the exchange market allows bonds to be traded amongst Chinese investors in Shanghai and Shenzhen. On the other hand, the China Interbank Bond Market (CIBM) was created in 2010 to give access to Chinese fixed-income products to foreign central banks, RMB clearinghouses, and overseas institutions engaged in RMB trade. The latter however recently evolved in 2016.

So far, however, the contribution of foreign investors to the Chinese bond market has been very limited because of various policy, regulatory and structural reasons that have either prevented or deterred foreign investors from stepping in. The Chinese State Administration of Foreign Exchange (SAFE) declared that the recent opening of the CIBM market had already improved the participation of foreign institutions (SAFE, 27/02/2017). In reality, however, overseas investors hold slightly more than 1 percent of the market (Bloomberg, 28/02/2017). Hence, putting the Hong Kong – China Bond Connect into place is all about increasing the numbers.

The Hong Kong – China ‘Connect’ schemes

Foreign financial institutions investing in fixed-income products have benefited from various capital market development schemes over the past years. In fact, the Hong Kong – China ‘Bond Connect’ is largely in line with other stock and bond-trading mechanisms set-up by Beijing.

On the one hand, the ‘Stock Connect’ system has given foreign investors the ability to access shares in mainland-based companies (the so-called ‘A shares’) and traded in RMB on the Shanghai and Shenzhen stock exchanges (respectively since November 2014 since December 2016) through the intermediary of the Hong Kong exchange. At the same time, mainland-investors have similarly gained access to Hong Kong-traded shares.

On the other hand, foreign institutional investors – such as commercial banks, asset managers, securities houses, pension funds, etc. – approved by the People’s Bank of China (PBoC) have been progressively given access to the ‘onshore’ domestic bond market.

Since the years 2010, in particular, these investors have benefited from the Qualified Foreign Institutional Investor (QFII) scheme and the Renminbi Foreign Institutional Investor (RQFII) scheme which have liberalized access to mainland bond markets.

These schemes have however required the opening of mainland-based accounts and have imposed significant investment quotas to the foreign investors. Investors, in addition, have had to meet some eligibility criteria, such as minimum fund size, the location of fund registration and management, and geographical asset allocation in order to participate in the schemes.

So?

In other words, foreign financial institutions’ access to the Chinese capital and bond markets has been facilitated, but only to a certain extent.

Hence, addition reforms have been put into place. Since February 2016, Beijing has facilitated the foreign institutional investors’ access to the CIBM market. The applicable legal framework has been altered to ease QFIIs and RQFIIs pre-approval requirements, investment quotas have been reviewed, and administrative delays have been reduced from 12-18 months to 6-8 weeks while the limitations imposed on the repatriation of invested funds have been lowered. According to the Chinese Foreign Exchange authority, in fact:

“Under the principle of real business, foreign institutional investors can choose their foreign exchange derivatives tools according to their own exposure to foreign exchange risk of single bond or bond portfolio, and use the trading mechanism” (SAFE 27/02/2017 – in Chinese)

Framework evolutions

While the above suggests that the current market regulations put in place in China allow foreign institutional investors to invest in the Chinese fixed-income market, the announcement by Premier Li that the Hong Kong – China Bond Connect would be set up by the end of the year has therefore raised various questions.

Beneficial impact?

In particular, there seems to be little consensus amongst analysts and investors as to what extent the initiative could have practical and beneficial impacts.

Some see that the Hong Kong Bond Connect will liberalize the system by granting access to the Chinese bond market to non-institutional individual ‘retail’ investors – in contrast with foreign institutional investors. These commentators expect that Connect might increase liquidities and help including Chinese bonds in global indices, and suggest that the system will ‘open up a much bigger universe of bond products’ thus enabling innovation in the design of new debt products (AAM, 17/03/2017).

Practical issues?

Others emit interrogations as to how the process will work in practice. They suggest that the impact on retail investors will be limited considering the respective sizes of both markets, formulate rather skeptical comments as to the redundant nature of the effort and highlight that retail investors can in any way already access the bond market through mutual funds offering daily liquidity. Some – like the Nikkei Review – especially emphasizes that the Chinese authorities have already opened the country’s bond market to foreign financial institutions (notwithstanding quotas) and note that in any case, the bond-related activity in Hong Kong is limited in comparison. USD 400 billion according to the 2016 FSDC report against USD 9.3 trillion in China, in fact. Overall, the review thus describes the initiative as a ‘sideshow’ and concludes that while the Chinese market is traditionally dominated by large state banks the credit quality of issuers will remain a major source of concerns:

‘… the credit quality of issuers is a growing problem, and although defaults are growing, even among state-owned enterprises, few think that bond prices properly reflect credit quality in China’ (Nikkei 22/03/2017)

Strategic perspectives

The main question, however, stays with the strategy behind the initiative. Here, different perspectives can be mentioned.

Mainland China strategy

From the perspective of Chinese markets, the Bond Connect is about changing dynamics.

In line with significant efforts conducted recently to internationalize the RMB, the Bond Connect is the logical continuity of various capital market liberalization efforts.

First, the goal for the People’s Bank of China when opening its bond market to foreign institutional investors is to attract long-term capital inflows that until now were deterred from entering Chinese onshore markets for structural reasons. As emphasized in the 2016 FSDC policy report on the future of Fintech in Hong Kong:

19. Neither QFII nor RQFII investors [were] keen on investing in the Mainland’s bond market. As of the end of 2014, only 10% of QFIIs’ total portfolios were invested in the Mainland’s bond market. As of the end of March 2016, there are 65 unlisted RQFII funds and 25 RQFII ETFs approved by the SFC. Only four of 25 RQFII ETFs invest solely in the Mainland’s bond market.

20. Similarly, only one-third of 37 approved Mainland funds under the MRF scheme have invested in the Mainland’s bond market, and only four of them are sole bond funds, as of the end of June 2016.

21. According to recent data, the average trading volume of the four RQFII ETFs investing in the Mainland’s bond market was only 1% of the overall average trading volume of all ETFs listed on the HKSE

Financial tensions.

China and the PBoC are also facing some credit and market financing difficulties. In March, for instance, reports indicated that tightened credit flows had increased short-term borrowing costs together with inter-bank credit rates while reducing liquidities.

As a result, some small domestic banks had difficulties borrowing funds thus forcing the PBoC to inject additional cash into the economy (amounting to USD 43.6 billion) so as to compensate the shortage. In addition, those monetary policies have given holders of Chinese bonds more reasons to sell their assets to compensate liquidity falls and, by the same token, have further increased the cost of borrowing for bond issuers thus delaying billions in bond issuance (TWSJ, 23/03/2017 and 13/04/2017)

Confidence issues

These efforts to open the bond markets to foreign capitals also flow from the necessity to increase confidence in the Chinese financial system. Slowing economic results are pushing investors to more lucrative and potential more stable markets, the late RMB depreciation and the continuing capital outflows have negatively impacted demand for RMB-denominated products.

The public policies increasingly aiming at allowing the default of zombie corporations have led to 9 defaults for the first quarter of 2017 and 29 defaults in 2016 (Bloomberg 03/04/2017). Not to mention the decision of MSCI to further exclude mainland-listed ‘A shares’ from its key emerging markets index in 2016.

Financing needs

All in all, recent developments point at important financing needs and the Connect developments (including the Hong Kong – China Bond Connect) aim at improving the perception of China’s financial environment and at stabilizing the country’s financial markets to promote foreign investment in RMB-denominated assets in general.

To do so, relying on Hong Kong’s stable and business-friendly reputation is a key argument and would surely allow Beijing to benefit from the aura and financial power of Asia’s largest financial hub. In Premier Li’s words, ‘This is what the country needs, and Hong Kong has the platform’ (Bloomberg, 15/03/2017).

Strategic Perspectives: Hong Kong

From the perspective of Hong Kong, the main stake is to further the city’s position as the main RMB dealer and as the region’s financial leader.

The initiative is being supported as part of the policy advisory activities of the Financial Services Development Council and has been largely integrated into the strategic plan for 2016-2018 of Hong Kong Exchanges & Clearing Ltd (HKEX), the entity in charge of operating the stock market and futures market in Hong Kong.

The HKEX strategy plan insists on the importance of ‘expanding and scaling the Connect model … and modernizing [Hong Kong’s] core platforms and market microstructure to deliver an integrated trading and clearing solution that breaks down the barriers for cross-border capital flows’. In line with the developments operated over the past years, the emphasis has therefore been put on three issues, i.e. equity (through the extension of the Shanghai and Shenzhen Connects), commodities and fixed income & currency (including the Bond Connect scheme).

The Bond Connect is thus described as a breakthrough towards developing the Chinese capital markets and as an opportunity to further improve the transactional activities of Hong Kong, while giving it even more influence as the ‘Global Offshore Renminbi Business Hub’ as formulated by the Hong Kong Monetary Authority.

Ambitious goal.

The goal is certainly ambitious, but the city has assets to capitalize on. While the Yuan’s integration in the IMF’s SDR currency basket last year is expected to increase the weight of the RMB in global currency trading, mainland China remains a major regulatory concern and risk for many investors. Hong Kong’s regulatory environment, in contrast, is perceived as stable and would thus help to reinforce the city’s position as an entry gate to China. Given ongoing Yuan depreciation, in addition, mainland investors might use the Bond Connect as a chance for diversification. Financially, therefore, it is expected that the Bond Connect might contribute to developing Hong Kong’s fixed-income market.

Analysis: Not quite there yet…

So far, however, the analysis remains speculation. Last month, the HKEX welcomed Premier Li’s announcement but emphasized that it was so far only making progress with preparatory work. The extent to which the Chinese authorities will allow outbound transactions to Hong Kong is for instance largely unclear while questions as to potential quotas, taxation or eligibility requirements will require some answers.

Nonetheless, the Bond Connect’s contribution to the Chinese credit situation is uncertain.

Simplification wanted.

First, comments formulated by analysts call for greater simplification in the processes and warn against the risk of excessively fragmenting mainland China’s capital markets (Lazuli International 24/03/2017). Second, the risk of losing potential investors cannot be ignored.

On the one hand, the reality is that the RQFII already grants a fairly large access to the Chinese interbank market. So far, the main limit of the system would be that the eligible investors remain institutional in nature but the market’s reach in itself is not at stake and the contribution of the retail sector might well remain limited. In fact, access to QFII and RQFII already allow access to markets to a much larger extent than the Hong Kong or Shenzhen connect since these only allow dealing with certain stocks.

On the other hand, there is significant uncertainty as to the big picture. In reality, the QFII scheme has already been replaced de facto by the RQFII, perceived by many fund managers as being more flexible and wide-reaching. Hence, questions remain as to (i) whether forthcoming developments related to the Bond Connect will create additional (overlapping) avenues to increase investment inflows and render previous schemes obsolete, or (ii) whether they would lead to significant market access reforms capable of reshuffling the cards.

Considering the complexity of the process required to gain access to the markets, some investors might decide to wait and see until a certain stabilization and harmonization of the measures and mechanisms can be seen. Furthermore, given the size of the existing institutional bond market, the real contribution of retail investors to Mainland China’s credit issues might remain limited.

The real big picture: greater integration

All in all, the Hong Kong – China Bond Connect clearly is about greater integration.

China and the world

Greater integration of China in the world’s increasingly globalized economy, first. As mentioned already, the RMB is now part of the IMF’s currency pool and China is making important efforts to give it more influence and resonance on the international financial scene. Thus, opening access to the Chinese Bond market is both a chance to attract foreign capitals and to make the RMB rise and shine.

In fact, the Bond Connect initiative makes part of a much wider connection project orchestrated by Beijing and involving other major financial hubs. In late March, China’s foreign exchange regulator (SAFE) for instance described the Bond Connect as one scheme amongst others aimed at improving ratings and financial environments in China. Similarly, the Chairman of Shanghai’s Clearing House – which oversees a major part of China’s inter-bank bond market – mentioned projects with several Clearing Houses in Europe as well as a necessity to align with these institutions’ standards.

Additional news furthermore suggests that one of the two European Central Securities Depositories (Clearstream) indicated that it would be establishing its own connectivity with the China Central Depository Clearing (Global Capital, 17/03/2017).

Hong Kong integration

The Bond Connect is finally about greater integration of China and Hong Kong into the Asia-Pacific region, as the effort will ultimately promote the two economies as major financial engines.

Hong Kong being the offshore RMB dealer, in addition, the Bond Connect is likely to give the city a boost. HKEX’s 2016-2018 strategic vision, in fact, is officially all about ‘connecting China with the World [and] extend and deepen HKEX’s value proposition against the backdrop of Mainland China’s accelerating capital market internationalization.

In this regard, it should be added that with the development of the One Belt One Road (OBOR) project, Hong Kong is already described as the dominating financing platform of the region. Hence, should OBOR’s investments in regional infrastructures give a boost to Mainland China’s debt market, Hong Kong’s fixed-income future might be even more favorable.