Beijing faces hurdles getting international investors on board with ‘bond connect’ scheme
Price distortion, infrastructure insufficiency and yuan depreciation expectations remain top concerns
Chinese authorities will have to solve several thorny issues facing the nation’s US$7 trillion bond market, from price distortion to infrastructure insufficiencies, before it can become a true global market and a new channel to attract international capital inflow, analysts said.
A bond connect scheme linking the Chinese mainland and Hong Kong will launch this year, allowing foreign investors to trade bonds on the mainland through Hong Kong and vice versa, Chinese premier Li Keqiang announced in mid March.
Later media reports said the new scheme would allow foreign investors to access the world’s second largest debt market by the end of this year, without the need to comply with a number of onshore procedures and formalities that are currently in place.
At present, bonds in China are traded on the China Interbank Bond Market (CIBM) and the domestic stock exchanges, with the CIBM capturing the lion’s share of the bond market.
China had opened CIBM to eligible foreign investors in February 2016, so many analysts expected the new scheme would include stock exchange traded bonds. However, a series of fundamental issues should be tackled to make the market attractive to foreign investors.
First of all, Chinese authorities will have to remove the “implicit guarantee” from the bond market to kick start a successful connect programme, said Ding Yuan, vice president and dean of the Shanghai-based China Europe International Business School (CEIBS).
The assumption that governments will not allow defaults to happen is the “implicit guarantee”, which largely distorts the price of Chinese bonds, Ding said.
“The vast majority of bonds in mainland China are rated as triple A by mainland rating agencies. If you ask them why the rating is so high, they explain it is because these are state-owned giants, with credit underwritten by the government,” Ding said.
“If foreign investors don’t buy into this pricing mechanism then China will not see the capital inflow it wants, no matter how the authority designs and promote the new scheme.
“However, if foreign investors jump into the casino and bet on the ‘implicit guarantee’, China will have to cope with a monster nurtured by huge capital inflows based on government buyout assumptions,” he added.
There is also key infrastructure lacking from the current bond trading system, said Ivan Chung, senior analyst with rating agency Moody’s, referring to an open quotation platform.
“Unlike stocks, the trading of bonds is usually completed through an over-the-counter market
“Right now, many domestic trading parties rely on WeChat groups to negotiate and decide the prices. I am not sure if international investors could deal with this,” Chung said.
An open quotation platform must be set up to guarantee the transparency of pricing and the reduction of transaction costs, he added.
“Besides market accessibility, a major obstacle that has prevented foreign investors from embracing yuan bonds is the concern about currency depreciation,” said Aidan Yao, senior emerging Asia economist at AXA Investment Manager.
Restoring investor confidence in China’s macro outlook can help dissipate yuan pessimism, he said.
On the other hand, it is important to offer investors currency hedging tools, Yao said.
The People’s Bank of China (PBOC) in February opened up the onshore derivative markets to CIBM investors for the purpose of currency hedging, which was to address the demand of international bond traders in China’s market, he added.
Foreign investors have been able to access Chinese bonds via the CIBM market since last year, and earlier through the QFII (qualified foreign institutional investor) and RQFII (renminbi qualified foreign institutional investor) programmes, but the bond connect scheme would open up a bigger universe of bond products, expand the capital inflow and outflow quotas, and simplify the trading process.
The announcement of the bond connect initiative comes more than two years after Beijing launched the Shanghai-Hong Kong Stock Connect, the first cross-border securities trading and clearing link, in November 2014.
Chinese authorities further expanded foreign investor access with the opening of the Shenzhen-Hong Kong Stock Connect in November 2016.
China’s bond market is the third largest in the world, estimated at around US$7 trillion, according to a HSBC report published in March.
However, foreign investors account for less than 2 per cent of the market, underlining the potential for growth if access is made easier.
When it comes to the size of corporate credit, China is now second only to the US.