China’s closer ties with Hong Kong’s bond market to create ‘enormous opportunities’ for city

Discussions have begun to allow Chinese investors to trade bonds in Hong Kong, a move that will “generate enormous opportunities” for the city’s financial services industry and has the potential to strengthen its status as an international financial centre.

The Hong Kong Monetary Authority (HKMA) and the People’s Bank of China (PBOC) will form a working group to study the framework for the so-called southbound leg of the current Bond Connect scheme, a HKMA spokesperson confirmed on Wednesday without providing a timeline.

Established in July 2017, the current Bond Connect scheme is a joint venture between the China Foreign Exchange Trade System & National Interbank Funding Centre and Hong Kong Exchanges and Clearing and allows foreign investors easier access to the mainland's onshore bond market through Hong Kong via the so-called northbound channel.

The current Stock Connect scheme already allows stock trading in both directions between the Hong Kong, Shanghai and Shenzhen stock exchanges, and the success of both programmes has laid the foundations for the possibility of the southbound leg of the Bond Connect channel.

“Launching Southbound Bond Connect will further enhance the mutual access between the capital markets of the two places,” said HKMA chief executive Eddie Yue Wai-man. “It will generate enormous opportunities for Hong Kong’s financial services industry.”

The proposal, along with plans to open up other mutual access investment schemes for the insurance and asset management sectors within the Greater Bay Area, signal “important structural changes” for Hong Kong’s development into a major wealth management centre for Chinese clients, according to Alicia Garcia-Herrero, Asia Pacific chief economist at investment firm Natixis.

But Garcia-Herrero cautioned that the details of the plan, such as whether they will be allowed to invest in foreign currency-denominated bonds or just yuan products in Hong Kong, as well as the implementation and mechanism of the mutual access investment scheme, remain unclear. In addition, the pace that China will allow its citizens to take money out of the country is likely to be slow at first.

“More Chinese companies would want to come to Hong Kong to issue [yuan and US dollar-denominated] bonds when Chinese residents are eventually allowed to purchase them,” Garcia-Herrero said. “At the end of the day, there could be a bigger pool of US dollar assets coming from the mainland.”

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China imposes strict capital controls on its citizens because of fears of a large financial exodus that could spark a stampede out of the yuan.

But with its extensive business and financial links with China, over the past 15 years Hong Kong has been supplementing the mainland’s long term goal of opening up its capital account and increasing the use of the yuan.

Tai Hui, Asia chief market strategist at JP Morgan Asset Management, said that rapid appreciation of the yuan’s exchange rate this year has given Beijing the confidence to accelerate the process of increasing the international use of its currency and attract more global capital into its yuan-denominated fixed income and equities financial markets.

The yuan appreciated against the US dollar for a sixth straight month in November, marking its longest streak in six years. The yuan is up 5.7 per cent against the US dollar this year, making it the best performer among the 11 most highly traded Asian currencies.

“When you get yuan strength, authorities can use this as an opportunity for capital account liberalisation,” Hui said. “These policies will introduce more two-way risk so that it is not just a one-way [yuan appreciation] bet.”

Hong Kong has established a foreign exchange market for the yuan – the so-called offshore market – and maintains the world’s largest yuan liquidity pool outside of China of more than 600 billion yuan (US$91.5 billion).

In anticipation of greater cross border transactions in the yuan, last week the HKMA and the PBOC renewed their bilateral local currency swap scheme, and expanded its scale to 500 billion yuan from 400 billion yuan.

The scheme allows the HKMA to obtain yuan at short notice if there is a liquidity shortage in the offshore yuan market, so that it can supply the currency to the banking system and prevent a surge in yuan interest rates.

The PBOC has signed currency swap agreements worth 3.47 trillion yuan (US$529 billion) with 39 countries in recent years, in the world‘s largest currency swap, to promote greater use of the yuan in international trade, investment and finance with foreign countries.

However, global adoption of the currency has lagged, with the yuan’s base still only small compared to the dominant position of the US dollar in international transactions.

According to the International Monetary Fund data, countries hold around US$230 billion of their reserves in yuan-denominated assets, or around 1.9 per cent of total global reserves, compared to the US dollar’s 61.3 per cent share.

Similarly, the share of yuan as an invoice currency covers only 1.66 per cent of global transactions versus 37.6 per cent for the US dollar, data from the SWIFT international transactions data service shows.

“The question is whether countries in the region will use yuan for their foreign exchange reserves,” said Deloitte China chief economist Sitao Xu.

“[China’s] ultimate goal is to achieve macroeconomic stability [through yuan internationalisation]. Greater flexibility in the yuan exchange rate would be in preparation [for this].”

China is aiming to reduce its dependence on the US dollar by speeding up yuan internationalisation amid the escalating conflict between the world’s two largest economies.

Greater use of the yuan could reduce China’s dependence on the US dollar-based financial system and contain the damage of potential US sanctions on its institutions.

“The strategic goal for the yuan is to continuously enhance the industrial competitiveness of the real economy through technological innovation, industrial innovation and management innovation, so as to lay a solid foundation for the realisation of full yuan convertibility,” said PBOC vice-governor Chen Yulu.

“In the process of yuan internationalisation and financial innovation, we have the conditions and ability to lead the country and make greater achievements.”

Zhang Huanbo, deputy director of the Institute of American and European Studies at the China Centre for International Economic Exchanges, said that the strengthening of the financial market infrastructure for offshore yuan financial products is especially important in Asia-Pacific given the focus on infrastructure investment in the region.

Allies of China, including those that are part of its Belt and Road Initiative, are expected to have more bilateral trade contracts with China, said Iris Pang, Greater China chief economist at ING Bank.

China’s Baosteel and Australia’s Rio Tinto Group completed a first transaction using blockchain for the settlement of a 100 million yuan (US$15.3 million) transaction in May.

Including bilateral trades, the share of yuan in foreign trade transactions is actually as much as 15 per cent as of August, up from 5.5 per cent at the beginning of 2012, Pang said.

She added that more than 70 per cent of China’s commodity transactions, such as purchases of crude oil, iron ore, purified terephthalic acid and natural rubber, from offshore traders were denominated in yuan.

At the same time, following China’s implementation of reforms to boost foreigner ownership in its financial market, foreign investment in onshore yuan stocks and bonds increased 48.6 per cent in 2019 to 6.41 trillion yuan.

“Unless there is an acceleration of exchange rate liberalisation reform and capital account reform, the use of the yuan will only pick up gradually due to the country’s unwillingness to fully liberalise capital flows,” added Pang.