Opinion: China Bond Connect Raises Thicket of Practical Questions for Foreign Investors
When Carrie Lam Cheng Yuet-ngor was formally appointed chief executive of Hong Kong earlier this month, Premier Li Keqiang said the central government was looking to develop the Guangdong-Hong Kong-Macau Bay Area as a major financial hub and launch a bond trading link.
In a news conference held during the annual National People’s Congress, Li said China was planning to start a trial “bond connect” program between the Chinese mainland and Hong Kong this year, allowing overseas investors to purchase onshore bonds from abroad.
Undoubtedly, the bond connect program is a major long-awaited measure to open up Chinese financial markets after the launch of two-way trading between Hong Kong’s stock market and bourses in Shanghai and Shenzhen. It is also considered a key step to expand the use of the yuan in international markets.
Based on the lessons learned from operating the stock connect programs, in order to allay foreign investors’ concerns, securities regulators need to clarify rules quickly and ensure extensive consultation with investors in the fixed-income market before the formal issuance of relevant laws and regulations.
At the end of 2016, about 63.7 trillion yuan ($9.25 trillion) worth of bonds was under custody in China’s bond market, the world’s third-largest market after the U.S. and Japan. But so far, foreign investors have managed to grab only a small share of it. By the end of February, foreign institutional investors accounted for only 2.86% of the participants in the interbank bond market in China, with bonds under custody representing no more than 2% of the total. This is not only lower than the U.S. and Japan, but also bond markets in many emerging economies.
China has been gradually opening its bond market. In 2010, the People’s Bank of China (PBOC), the central bank, allowed three kinds of foreign financial institutions to trade on the mainland interbank bond market: yuan-clearing banks in Hong Kong and Macau, foreign central banks involved in currency swap deals with Beijing, and international banks participating in yuan settlements. In 2016, China expanded access to its interbank debt market to all types of foreign financial institutions, and scrapped investment quotas for medium- and long-term investors.
Meanwhile, the inclusion of the yuan in the Special Drawing Rights (SDR) basket of currencies and the creation of a parallel index by Bloomberg Barclays that incorporated Chinese onshore government and policy bonds drove up demand for yuan bonds.
Under the current regulatory framework, foreign investors must entrust trading and settlement to qualified Chinese agents, which dampens the enthusiasm of foreign investors. The key aspect of the bond connect program is to allow foreign investors to purchase Chinese onshore bonds from abroad, which is expected to boost investment by overseas investors.
However, the Chinese government has not released any details about the program, provoking speculation among overseas investors.
Investors expect the bond connect program to include the interbank bond market. But it is an over-the-counter (OTC) market outside the Shanghai and Shenzhen stock exchanges, with completely different price-bidding and trading mechanisms. As a result, the bond connect program cannot completely follow the practices employed in the stock connect programs. If foreign investors are not required to conduct trading and settlement via domestic agents, then a system needs to be set up to link the trading and settlement businesses conducted at home and abroad, in which Hong Kong may play a bridging role.
In addition to trading bonds between foreign and domestic investors, the idea of allowing foreign investors to buy and sell bonds among themselves is also worth considering. For overseas investors, the best way to place investment orders to trade Chinese onshore bonds is via a foreign trading platform such as TradeWeb or Bloomberg.
The extent of the role of the domestic trading system, the China Foreign Exchange Trading System (CFETS), remains under question, as does how it will need to be upgraded when the bond connect program is launched. Under the current rules, when a manager needs to trade with multiple funds, transaction details for each fund need to be input into the CFETS when an order is placed. This is time-consuming and far less efficient than “block booking” — submitting an order for the sale or purchase of a large quantity of securities.
If the central bank extends current regulations over foreign investors to the interbank bond market, overseas institutional investors in the bond connect program will be exempt from some qualification requirements, and there will be no limit on their investment quotas.
Foreign investors want to engage in all kinds of debt instrument trading, including spot transactions, repurchasing, bond lending, trading bonds in forwards markets, interest rate swaps, and forward rate agreements. It is likely that the bond connect program will give foreigners access to spot transactions and some derivatives. Also, foreign investors hope they will be able to trade foreign exchange derivatives to hedge against currency risks.
Foreign investors are also concerned about ownership. Under the stock connect programs, investors are beneficial owners of shares, which means shares are held by Hong Kong Exchanges and Clearing Ltd. in a so-called omnibus nominee account. This arrangement raised concerns among foreign investors, which were not effectively allayed until securities regulators on the mainland and Hong Kong issued an explanatory statement.
Under the bond connect program, foreign investors will want to continue using existing bond accounts opened through international central securities depositories (ICSDs) without the need to set up additional bond accounts in China. To achieve this, while fully safeguarding the ownership of bonds, there will need to be an intermediary to link foreign investors’ ICSD accounts with domestic organizations that provide settlement services. The best organization to play this intermediary role would be the Hong Kong Monetary Authority‘s Central Moneymarkets Unit.
Another concern that foreign investors have is whether they will be able to dispose of their bonds freely. Foreign investors want to pledge bonds they hold as collateral to secure financing both at home and abroad. But the current legal framework in China may not support this, as foreign investors may not have their own bond account in China under the connect program.
Finally, the relationship between the bond connect and the current Qualified Foreign Institutional Investors and Renminbi Qualified Foreign Institutional Investors programs needs to be addressed; otherwise, foreign investors who came to the Chinese market earlier under these investment channels might feel they are being unfairly treated.
Ge Yin is head of the financial services sector in the Shanghai office of Clifford Chance LLP, a multinational law firm based in London.
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