Beijing is expected to loosen capital controls further to give mainland investors a new outbound channel to buy bonds in Hong Kong, providing investment alternatives for Chinese households and companies while boosting liquidity in the city and cementing its status as a global financial hub, analysts said.
The so-called southbound link of China’s Bond Connect scheme is likely to be implemented in the second half of the year, Hong Kong’s financial secretary Paul Chan Mo-po was quoted as saying by the Hong Kong Economic Journal on Monday.
Details of the bond investment framework are expected this month, with trading beginning as early as July 2, a gift from Beijing to Hong Kong to celebrate the 24th anniversary of the city’s return to Chinese rule, the report said.
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“Currently onshore investors can invest into the offshore bond market via qualified domestic institutional investor (QDII) quotas but the southbound link would offer them a more convenient channel,” said Angus To, a fixed income analyst at ICBC International.
“The opening of the southbound link will allow onshore capital to flow into the offshore bond market, and would also provide additional capital to Hong Kong and strengthen its role as a key platform in bond finance.”
David Yim, head of capital markets for Greater China and North Asia at Standard Chartered, said demand for overseas financial products from Chinese investors has been growing in recent years. Investors are looking to diversify their portfolios and enjoy higher returns from the wider range of financial products available in Hong Kong compared to the mainland.
But southbound market access might initially be much more constrained than the northbound Bond Connect, which was launched in 2017 and has few restrictions on foreign investors in the mainland market, Yim said.
So far, 640 investors have been approved to use the northbound Bond Connect to access China’s US$13.9 trillion bond market. Foreign holdings of yuan-denominated bonds via northbound investment surged 57 per cent from a year earlier to reach a peak of 3.57 trillion yuan (US$55 billion) in February, before slipping to 3.56 trillion yuan in March, driven by index inclusions and the appeal of higher yields on Chinese bonds compared to those in the US and Europe.
Beijing may be comfortable now opening up its capital account to allow bigger outflows out of the country given signs of stability in the demand for the yuan
China is among the world’s least financially open economies because it imposes stringent capital controls to limit the flow of foreign funds into and out of the country, fearing an exodus of money in a crisis could spark a stampede out of the yuan exchange rate.
But to boost international use of its currency, the People’s Bank of China is increasing capital mobility in a controlled way through market access programmes such as the Bond Connect, Stock Connect and Wealth Management Connect. It is also expanding the quota for the QDII and Qualified Domestic Limited Partnership programme.
“As long as northbound flows remain sustainable, the impact from opening up the southbound channel to China’s onshore market will be small,” said Frances Cheung, global treasury research and rates strategist at OCBC Bank.
“Beijing may be comfortable now opening up its capital account to allow bigger outflows out of the country given signs of stability in the demand for the yuan.”
The yuan’s exchange rate hit its highest level in three years at 6.46 per US dollar earlier this year before stabilising in a narrow range between 6.48 and 6.60 per dollar. The lower the exchange rate, the stronger the yuan, given it takes fewer yuan to buy one dollar.
Still, authorities would likely take a calibrated approach to approving the number of investors who can use the programme. The scope of investment products would likely begin with “dim sum bonds”, yuan-denominated bonds issued in Hong Kong, said Freddy Wong, head of Asia-Pacific for Invesco Fixed Income.
To ensure the smooth and transparent settlement of transactions, Chinese investors may be limited to bonds held with the Central Moneymarkets Unit – the computerised clearing system operated by the Hong Kong Monetary Authority, or to those listed on the Hong Kong exchange, Wong said.
At the same time, US dollar bonds issued by Chinese firms will be high on the southbound wish list of Chinese investors, because of familiarity with these issuers that pay higher returns compared to yuan-denominated bonds sold in the onshore market, Wong said.
“It is unclear if the Chinese [US dollar-denominated] property bonds would be included in the scope of the southbound link but opening them up to onshore investors would be very significant and can provide liquidity to these issuers,” Wong said.
So far this year, issuance of dollar bonds by Chinese firms has remained resilient, growing 19 per cent, with a sizeable amount coming from property developers amid a post-pandemic boom in the mainland real estate market, according to France’s Natixis Bank.
The further integration of Chinese and international financial markets could also help the growth of foreign financial firms on the mainland.
Chinese clients, who have borrowed trillions of US dollars and hold large US dollar foreign deposits, will increasingly need a full suite of trading services, from futures, options, cash and over-the-counter products to manage their international trade and hedge investment risks, said Christopher Fix, managing director and head of Asia-Pacific at the CME Group, the Chicago-based financial exchange company.
As the Bond Connect opens its southbound link, CME Group’s EBS CNH benchmark – the offshore yuan daily reference rate that supports benchmarking in the global derivatives and currency markets – saw its volume rise 9 per cent in January, the biggest increase since July 2018, amid sizeable flows into China, Fix said.
“There are onshore clients who need to have the exposure to the offshore bonds who aren’t getting what they need from the internal bond market,” Fix said. “We think that’s going to be a real future growth story for us to have the cash and the futures alongside each other.”
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