China’s bond market is developing rapidly. Over the years, the market has seen increased issuance and heightened investor interest. Still at the same time, the market has witnessed turbulence: Moody’s Investor Services downgraded China’s sovereign rating in May; and the yield curve has inverted as a result.
Despite these events, we believe that China’s bond market remains an attractive long-term proposition, particularly with programs such as “Bond Connect” that will help deepen reforms and bridge China’s bond market to the world.
A rapidly-growing market – albeit a volatile one
China’s bond market has posted significant growth over the past five years. According to China Central Depository & Clearing Co, bond Issuance has grown an average of 21 percent from 2011-2016.
Although much of the issuance has been on government debt, China’s nascent corporate market is also gradually expanding, drawing investor interest. China is today home to the third-largest bond market in the world.
Despite these accomplishments, the market has experienced increased volatility, on the back of government policies to deleverage the Chinese economy, as well as growing debt levels which was a reason cited by Moody’s for its credit downgrade in May.
Structural issues crucial to market development
Nevertheless, we view these events as part of China bond market’s long-term development, which also includes important structural issues.
One of the key structural issues is the low levels of foreign ownership in China’s bond market. Foreigners currently own only 2.7 percent (US$243 billion) of bonds in China. They also make up a lower proportion of the sovereign bond market in China, compared to other countries. As at end-2016, foreign investors only owned 4 percent of the Chinese sovereign bond market – a level below that of even India (6 percent) and Egypt (9 percent).
Second, onerous on-shore applications may have discouraged some investors. Currently, investors looking to invest in China must apply for a license and create an account onshore, or via a lengthy administrative and setup process with local custodians and clearing agents, which also makes it more difficult to repatriate money out of the country.
Bond Connect program to enhance investor access
The Bond Connect program, announced by the People’s Bank of China and the Hong Kong Monetary Authority in May, will address some of these issues linking up the offshore and onshore bond market.
The program will initially allow international institutional investors (i.e. northbound) to invest in China’s Inter-Bank Bond Market (CIBM) via a convenient market infrastructure linkage in Hong Kong. Reciprocal access to Hong Kong’s market is expected to be introduced later.
A potential game-changer
As a major bond investor in China that has participated in programs such as QFII, dim sum bond offerings, and CIBM, we see Bond Connect as a transformative program for two reasons.
First, the program will serve as a bridge to foreign investors, just like the Shanghai-Hong Kong Stock Connect. Stock Connect has had a positive effect on increasing volumes between markets and catalyzed China’s equity market liberalization. MSCI’s announcement in June to include China in its benchmark indices after three rejections is a direct result of this program.
We envisage similar success for Bond Connect in China’s institutional space: improved volumes, increased foreign participation, and the ultimate inclusion of China in global fixed income indices. We estimate that China’s inclusion in global bond indices could lead to a potential capital inflow of US$650 billion to US$750 billion in passive demand. Foreign investors may ultimately provide a layer of institutional investment that might dampen market volatility, through a broader and more diversified investor base.
Second, the program will likely have a positive impact on key economic goals such as capital account liberalization and promotion of the RMB globally. Opening up onshore bond access is another important step for the government to liberalize the capital account, while foreign investors holding onshore RMB bonds will increase demand for the currency.
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