Transformation and Internationalization of China bond market

Craig McLeod January 25, 2021 09:36

Tectonic shifts in technology and the transformation of global finance over the past two decades have dramatically changed the way investors trade bonds. Nowhere is this more evident than in the opening up of mainland China’s bond market.

The gradual transformation of China’s $15 trillion debt market offers one of the best examples of how an individual economy can take advantage of recent advances in financial services. Just five years ago, only a very limited number of foreign institutional investors were able to invest in China’s onshore bond market. But thanks to regulators’ efforts in lowering barriers and to developments in electronic trading, overseas ownership of Chinese credit is now at a record high. During the same period the Chinese bond market has grown into the world’s second largest, behind only the U.S.

Besides China’s economic prospects, its bond market has a number of unique features that make it attractive to foreign investors. Renminbi-denominated bonds also lack many of the weaknesses and vulnerabilities that plague other emerging market debt.

First, China’s ability to service and repay its debt. While the prospect of corporate defaults are causing some investors concern, others view them as a further sign that the market is maturing and welcome the ability to more accurately price risk. More importantly, the underlying strength of China’s bond market is reflected by the country’s A+ sovereign credit rating, which acts as a reassurance to international investors concerned with credit quality. Economists and analysts have also long pointed out that China’s debt growth has largely been fueled by a reallocation of domestic capital and savings from consumption to longer-term investments.

Secondly, the country’s national debt is supported by its large foreign exchange reserves, which stood at US$3.4 trillion in January 2020. While significantly down from the US$4 trillion level they reached in 2014, they are still the world’s biggest by a wide margin.

Another feature that helps China stand out among its peers is the willingness and determination of its government to integrate the country’s financial markets with the global system. Since I began looking at onshore Chinese bonds about eight years ago, I have seen firsthand how this mindset has helped bring tremendous improvements to market transparency and liquidity.

One example of this is the setting up of trading workflows aligned to global best practice, enabling foreign asset managers to fulfil their own best execution obligations. Another is the creation and enforcement of market transparency through the introduction of indicative dealer prices to the global investor community. China has also implemented new trading protocols driven by global demand, as well as established an advanced system for reporting market volumes and make-up.

Starting in 2016, Chinese regulators have been dismantling entry barriers for foreign investors seeking to access its onshore bond market, showing great flexibility and nimbleness during the process. These deliberate policy changes have been instrumental in triggering notable shifts in investor attitudes towards Chinese bonds.

Today, there are four main ways investors can access the onshore interbank and exchange markets: a direct access scheme, the Qualified Foreign Institutional Investors (QFII) and Renminbi Qualified Foreign Institutional Investors (RQFII) schemes, and the Bond Connect program. All four methods provide flexible treatment on currency conversions as well as faster and quota-free access to the Chinese Interbank Bond Market.

Bond Connect in particular has become one of the most celebrated aspects of China’s capital markets development since its introduction in 2016. Thanks to the program’s success in raising international investor participation, Chinese bonds have gained significant weighting in global fixed income indices. Their continued inclusion in benchmarks is expected to drive even more capital flows, which will in turn encourage better liquidity and further structural improvements to China’s local bond markets.

These developments are undoubtedly exciting, but some hurdles remain for foreign investors in understanding and trading the onshore market. Trusted pricing, trade liquidity and data accuracy, previously viewed by investors with some skepticism in China, are all areas that are seeing great improvement. Another aspect of the market that many foreign firms find unfamiliar is the co-existence of the two separate bond trading venues and the three regulators that oversee them. Overlapping regulatory responsibilities can sometimes lead to confusion for both issuers and investors.

There are plenty of reasons to be optimistic, as regulators seem to have set their sights on addressing this situation. In July 2020, the central bank and securities regulator announced that bond traders on the interbank market and stock exchanges could now trade bonds listed on both venues. This marked an important step for the integration of China’s fragmented bond markets, and is sure to be a sign of more things to come.

Watching the development of China’s bond markets over the last few years has been an object lesson in how technological advancement, regulatory change and investor interest can all come together to transform finance for the better. While much has been achieved, it’s still early days and there are many exciting developments to come. International participation in China’s government and credit markets has only just begun.

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Craig McLeod

Head of Emerging Markets, MarketAxess