The "Bond Connect" scheme that provides a new channel for foreign investors to access China's onshore interbank bond market (CIBM) is another example of the authorities' recent efforts to encourage portfolio inflows, and may help put renminbi internationalization back on track after a lack of progress in recent years, says Fitch Ratings.
The scheme, launched on 3 July, is part of broader government reforms to open up China's onshore bond market, the third largest in the world after the US and Japan.
Since February 2016 foreign institutional investors approved by the regulator have had access to CIBM through the CIBM Direct scheme which imposes no quota limitations or restrictions on repatriation, unlike previous schemes.
Foreign participation in China's bond market has risen in response to this liberalization, but remains low by regional standards. Foreign holdings of Chinese government bonds had increased to 3.9% by end-May 2017, up from 3% a year earlier, while external holdings of policy financial bonds had risen to 2.3% from 1.7%.
Foreign participation in the total onshore market is even lower. In comparison, the share of government bonds held externally was 25.6% in Malaysia, 10.5% in Korea and 10.5% in Japan, according to the Asian Development Bank.
The Bond Connect scheme should facilitate higher foreign ownership of onshore bonds over the medium term. Bond Connect's main advantage over CIBM Direct is that regulatory approval is not required to invest in fixed-income products in CIMB.
Foreign institutional investors only need to set up a Bond Connect account with a participating Hong Kong bank. Investors will convert foreign currency to offshore yuan (CNH) to invest in onshore bonds. The scheme will also allow investors to use a familiar online platform to trade in the CIBM.
Wider inclusion of Chinese bonds in major indices
Improved foreign access to the onshore bond market may encourage wider inclusion of Chinese bonds in major indices, which could further boost foreign investment. Bond Connect should also bolster growth of fixed-income professionals capable of selling Chinese securities to foreign investors, which will be important in expanding foreign participation.
However, the government is likely to continue to tread carefully over broader capital account liberalization, given the potential risks that net outflows could pose to financial stability. Accordingly, Bond Connect does not yet allow Chinese investors to buy overseas bonds - it is north-bound only - which is in keeping with our view that the authorities will remain cautious towards removing outflow restrictions, while loosening those on inflows only gradually.
Bond Connect also limits foreign investors' ability to engage in onshore currency arbitrage, restricting access to onshore rates and FX derivatives.
Bond Connect investors can instead hedge Chinese treasury rates through the Hong Kong Exchange and offshore FX rates via the OTC market. However, trading costs associated with offshore instruments can be high, and will be influenced by investors' views on CNH.
Portfolio liquidity management
Portfolio liquidity management will be important to Bond Connect investors as repurchase agreements cannot yet be conducted through the scheme. As such, Fitch expects funds to be invested primarily in liquid instruments, such as government bonds, policy bank bonds and negotiable certificates of deposit.
Bond Connect investors will have access to state-owned unlisted 'enterprise bonds' traded on the CIBM, but not to corporate bonds issued in the exchange markets.
Hong Kong banks participating in Bond Connect are likely to generate additional fee and FX income, but could also face increased operational risks and costs, owing to compliance, reporting and trade-settlement obligations.
“Larger banks could purchase and sell bonds via Bond Connect as part of their balance-sheet management, but we do not expect this to result in a significant increase in system-wide mainland China exposure,” says Fitch.