China Allows Foreign Bond Investors to Trade Derivatives for Hedging

(Beijing) – China further opens its foreign exchange market, allowing overseas investors in its interbank bond market to trade derivatives for hedging currency risk. The move will encourage capital inflows, analysts said.

The State Administration of Foreign Exchange, the country’s foreign exchange regulator, said Monday in a statement that foreign investors can now use derivatives such as forward contracts, swaps and options to manage currency risk on investments in China’s interbank bond market.

Non-central bank, foreign institutional investors, including pension funds, charities and other investors who invest in China’s bond market through the Qualified Foreign Institutional Investor and the RMB Qualified Foreign Institutional Investors programs can gain access to such trading, according to the agency.

Foreign investors must trade the derivatives through a qualified onshore financial institution and conduct such trading based on “real needs” for risk hedging, the SAFE said.

Analysts said the move is China’s latest effort to make its financial markets more attractive to overseas investors at a time of rapid capital outflows.

Chinese regulators have stepped up efforts to bolster the domestic bond market by relaxing restriction on foreign investors and granting them full access to the interbank bond market beginning last February. The opening of derivatives trading is a follow-up step to enable foreign bond investors to hedge foreign exchange exposure, an SAFE official told Caixin.

By the end of last year, more than 430 foreign investors held 870 billion yuan ($126.7 billion) of bonds in China’s interbank market, an increase of 83.4 billion yuan from a year earlier, SAFE said.

But foreign investor bondholding is still a tiny drop in the country’s 63.7 trillion yuan bond market, which has grown into the world’s third-largest. By the end of 2016, bonds traded on the interbank market totaled 56.3 trillion yuan, according to Pan Gongsheng, head of the SAFE.

Ivan Chung, a senior vice president of Moody's Investors Service in Asia Pacific, said that without access to China’s foreign exchange market, many foreign investors have been using derivatives at offshore yuan markets as hedging tools for investments in China’s bond market. But such practice is costly and time consuming.

The new rules will offer foreign investors more-convenient options for managing foreign exchange risk and will make the domestic bond market more appealing to overseas investors, said Chung.

Chinese authorities have accelerated the opening of the domestic bond market as part of efforts to promote international use of the yuan while seeking to balance cross-border capital flows amid concerns about capital outflows.

China’s foreign exchange reserves dropped to $2.998 trillion in January, breaking the psychological “comfort level” of $3 trillion for the first time since February 2011. But the January decline was the smallest in seven months, signaling an easing of capital outflows.

Ma Jun, chief research economist at the central bank, said last week that regulators are also studying several measures to encourage more foreign participation in the domestic bond market. These include tax policies for foreign bond investors, extended trading hours for the interbank bond market and longer transaction settlement periods for foreign investors.

Contact reporter Han Wei (weihan@caixin.com)