17 July 2018
China has the third largest bond market in the world, but only about 2 per cent is foreign-owned due to historical capital restrictions, one of the lowest rates among developed markets. A key channel for increasing foreign participation is the Bond Connect programme, which just passed its first anniversary and is set for a number of key upgrades in the coming months.
In our recent paper about the anticipated growth of this market, we discussed China’s two main markets for onshore bond transactions, the exchange-traded market and the interbank market. In recent years, foreign investors have been allowed greater participation in the more liquid China Interbank Bond Market (CIBM), which accounts for around 90 per cent of total trading volume.
Opening the door further
Prior to the launch a year ago, foreign investors looking to trade on the CIBM needed to go through a lengthier admission process and set up a domestic custodian account with an onshore settlement agent. Under Bond Connect, foreign investors can buy debt trading on the CIBM directly through the Central Moneymarket Unit with their offshore custodians. This streamlines and speeds up the investor onboarding process to two weeks or less, from around a month under the previous process.
Source: Bloomberg, Bank for International Settlements, PBOC, December 2016.
In a speech marking the scheme’s one-year anniversary on July 3, People’s Bank of China vice governor Pan Gongsheng announced changes to Bond Connect to remove most of the remaining roadblocks for foreign investors. These enhancements also help China’s onshore bond market meet the key requirements for inclusion in global indices like the Bloomberg-Barclays Global Aggregate index, which it will join in April 2019, as well as Citi’s World Government Bond Index (WGBI) and J.P.Morgan’s Government Bond Index- Emerging Markets (GBI-EM). Overall, we estimate potential inflows of approximately $280 billion in three to five years, based on the assets under management of all the passive funds tracking these three indices, and the weighting onshore China is expected to have.
Source: Fidelity International, March 2018. GBI-EM refers to the JPMorgan Government Bond Index - Emerging Markets. WGBI refers to the Citi World Government Bond Index.
Bond Connect 2.0
The most important upgrades to Bond Connect are block trading and delivery versus payment. Block trading allows buying a bond and splitting it into multiple funds. Delivery versus payment (DVP) means trades are settled with delivery versus payment on the same day, which reduces counterparty risks for investors. Block trading makes Bond Connect more relevant for large asset management companies, while the DVP capability should attract heavily regulated foreign investors such as UCITS, insurers and pension funds to the Chinese market.
Besides these changes, policymakers said they would clarify a potential tax exemption for foreign investors in the mainland. The platform, a joint venture between the China Foreign Exchange Trade System and Hong Kong Exchanges and Clearing, also added repo operations and derivatives trading, another 10 market-makers including foreign banks like Bank of America Merrill Lynch, J.P. Morgan, and Mizuho Bank, and cut the trading platform fee.
The upgrades show China’s ongoing commitment to opening the onshore RMB bond market to offshore investors. Foreign holdings in China’s interbank bond market reached 1.4 trillion renminbi ($210 billion) at the end of May, an increase of 70 per cent since Bond Connect’s launch in July 2017. Average daily volumes in Bond Connect reached 6.6 billion renminbi in June 2018, more than double the daily average volumes in the first quarter of the year. Trading volume in June reached 130.9 billion renminbi, nearly double the volumes in May.
Bond Connect greatly widens the scope for foreign participation in China’s onshore market, as the scheme has no investment quota or the need to specify an intended investment amount. At a higher level, the advent and ongoing improvements to Bond Connect also strengthen Hong Kong’s numerous roles as an international financial centre, access point to mainland China markets and trading hub for offshore renminbi.
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