Connect programmes using Hong Kong’s strengths to cement key place in China’s opening-up

As the Connect programmes evolve, it has become clear that Hong Kong’s role will not diminish as access to its and the mainland’s markets increases
Its concentration of financial and legal expertise remains a key factor for the continued success of programmes in the Connect series

James Sun

Published: 8:15am, 19 Jul 2023

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The 26th anniversary of Hong Kong’s return from British rule coincides with the sixth anniversary of Bond Connect, one of China’s five groundbreaking programmes that allow foreign and domestic investors access to the other’s securities markets. In many ways, the success of Bond Connect reflects aspects of Hong Kong that make such innovations possible.

Bond Connect is divided into the northbound and southbound channels. As with the equities-focused Stock Connect programme before it, the northbound channel lets foreign investors enter the mainland interbank bond market via Hong Kong.

Meanwhile, the southbound channel allows mainland institutional investors to invest in overseas bonds by moving funds to Hong Kong. Its most innovative feature is in letting participants in two different trading venues – Hong Kong and the mainland – transact with each other in ways which would not be possible elsewhere.

After Bond Connect was implemented, three major international bond indexes gradually included Chinese bonds. These are the Bloomberg Barclays Global Aggregate Index, JPMorgan Government Bond Index for emerging markets and FTSE Russell’s World Government Bond Index. This has prompted international investors to accelerate their entry into the market.

Since 2017, cross-border fixed income transactions have flourished in China. Last year, the volume of Chinese bonds traded rose by 25.8 per cent. As of the end of May, foreign capital holdings of yuan-denominated bonds reached 3.2 trillion yuan (US$448.2 billion), while this figure was only about 800 billion yuan before the implementation of the Bond Connect.

The launch of Swap Connect – the fifth in the Connect series, joining stocks, bonds, exchange-traded funds (ETFs) and wealth management markets – further bolsters foreign participation in China’s bond market with its offer of more effective hedging against interest rate risks. Roughly US$3 trillion of swaps trade each year onshore in China, representing a far deeper and more liquid market than the Hong Kong non-deliverables market previously used by foreigners to manage their rates and currency risk.

Chief Executive John Lee Ka-chiu speaks at the launch of the Swap Connect on July 4 last year. Photo: Handout

China’s State Council has made it clear it will continue to reform and liberalise access to its markets and has emphasised the role of finance in the economy’s high-level opening up. The world’s second-largest economy is becoming a core participant in a diversified currency system amid an interest rate raising cycle by major central banks and a strengthening US dollar.

At the same time, China’s industrial chain has also become an important part of the global economy, which in turn will hasten the internationalisation of the yuan. By all accounts, the government will continue to promote this.

At present, more than 30 countries have begun to adopt yuan settlement in foreign trade and investment in some form. Investors in these locations will need somewhere to deploy their yuan-denominated assets, which could be a boon for Hong Kong’s Connect programmes.

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The need to diversify doesn’t apply just to global investors. Within China, domestic capital continues to seek assets in other parts of the world, creating demand for products onshore such as bonds, ETFs and derivatives. The yield differential between Chinese and overseas debt assets, for example, is also boosting southbound demand for Bond Connect. China’s domestic markets continue to require more counterparties and innovative trading tools to maximise their efficiency and convenience.

As Bond Connect passes the six-year mark, participants in both directions can expect more enhancements, including more tools to manage interest rate risks. From its discussions with industry participants, Tradeweb understands that the programme’s investor base is likely to expand – the number of participants could more than double by the end of the year.

Work is being done to simplify filing procedures and reduce costs associated with the northbound channel, while new products such as repurchase agreements are being considered for inclusion.

Southbound domestic investors looking to participate overseas could soon also see lower costs and friendlier trading functions. On both sides, the number of dealers is expected to rise as licensing expands in response to demand.

As the programme evolves, it has also become clear that Hong Kong’s role will not diminish. The city’s concentration of financial and legal expertise remains a key factor for the continued success of Bond Connect and other programmes in the Connect series. The priority is for investors to have more flexibility and choice when trading global bonds, ultimately bringing more liquidity, efficiency and transparency to the marketplace.

James Sun is head of Asia at Tradeweb, responsible for all of the firm’s business operations in the region