Steve Wang and Zoe Chuang: The "Half-Opened" Mainland-HK Bond Connect

2017-06-01 IMI

Steve Wang, Senior Research Fellow of IMI, Head of Fixed Income Research, BOCI Zoe Chuang, BOCI

The PBOC and HKMA have officially announced the plan for the widely-anticipated Mainland-HK Bond Connect, China’s latest capital market opening scheme and a new capital market link between the mainland and Hong Kong.
The official announcements have divulged some key points of this “bond connect” scheme, but technical details and execution plans are sketchy. The market is expecting the scheme to start operation on1 July 2017.
The Connect’s initial phase will see a partial opening, following tremendous efforts from both the mainland and HK authorities. The Connect will be opened to northbound investors first and southbound ones later; to interbank bond market first and exchange bond market later; and to institutional investors first and individual investors later.
Although the limited scope of opening under the Connect programme will make the programme implementation relatively easy and smooth, some long-term issues need to be addressed, such as the integration of China’s segmented bond markets, the global trend of shifting securities trading from OTC model to exchange model, and the growth of China’s credit bond market.
The rapid development of Fintech could help to provide new solutions for the bond connect to tackle the traditional challenges and to step into the future during its next phase.

China’s latest capital market opening scheme, the Mainland-HK Bond Connect, has officially received a stamp of approval. Yesterday, after the market close, both the PBOC and HKMA posted official announcements regarding the plan to establish a cross-border link between China’s domestic bond market and the HK securities market, making the widely-anticipated bond market access a reality sooner than expected. Although the announcements have not specified the opening day of the bond connect (the media have been expecting debut on 1 July 2017, which will mark the 20^th anniversary of Hong Kong’s return to China and President Xi’s visit to Hong Kong) and there are few details on the technical and execution blueprint, a number of key features revealed on the scheme are significant for potential participants. “Northbound first and southbound later” The connect will be opened first to “northbound” HK investors and then to “southbound” Chinese investors. Such a design will make the connecting process easier, simpler and better-managed on the basis of one-way opening-up, and, meanwhile, meet the near-term needs of mainland authorities in dealing with the currently-elevated risk of capital outflows and in boosting capital inflows. This design also dovetails with the commonly-practised doctrine of mainland authorities to open up the Chinese capital markets in a measured, gradual and progressive approach in order to avoid causing major interruptions and instability in the financial market. In addition, this also marks the resolve from the mainland and HK to get the scheme started first in a limited scope at the earliest-possible time without being bogged down by a much more complex bond connect as compared to the existing Shanghai-HK and Shenzhen-HK stock connects. “Interbank market first and exchange market later” The current plan is to link China’s interbank bond market (CIBM), which makes up over 90% of the overall bond trading activities, with the HK market first, but lacks specifics for China’s exchange bond markets. This means bonds traded in the exchange market may not be opened to international investors in the initial phase. Although we had expected the opening-up of the exchange market in a bond-connect to be easy and simple, given the cross-border connects for exchange-traded stocks already in place, the priority given to the CIBM at the first stage is well thought out and designed to maximise the access for international investors to China’s bond market under the condition of limited opening. This is largely in line with the international investors’ current focus on the high-quality segment of the Chinese bond market, such as treasury bonds, policy bank bonds, financial bonds and the CP and repo markets. The high liquidity level and participation depth of the CIBM also offer key attractions for many of the major international investors in this market, such as FX reserve funds, sovereign wealth funds and international agencies, which have high level of demand for liquidity, safety and stability. “Institution investors first and retail investors later” Since the CIBM is opened only to institutional investors, in contrast to the exchange market opened to both institutional and individual investors, the initial phase of the bond connect will only be available to institution investors. This design also makes the operation of the connect easy to manage and to conduct, as these investors’ professional sophistication, familiarity with the Chinese market and investor pool concentration are high, and regulatory supervision can be carried out more efficiently and effectively. This measure could boost the certainty of a smooth sailing at the start of the bond connect. A few more thoughts We applaud the painstaking efforts and resolve from both the mainland authorities and HKSAR to establish the cross-border bond connect and to choose the much more complex CIBM as the initial target for market access. Since the connect will initially bypass the exchange traded bonds and instead reach out to the “OTC” characterised CIBM directly, it will set a much higher bar for the scheme to meet. When the plan is proven successful, adding the exchange-traded bonds to the connect at a later stage should be easy and natural. There are some long-term issues that we may also want to examine now. How China’s bond market will evolve in the long term has been a major subject of discussion and debate for quite some time. The policymakers have been promoting the linkage and integration of China’s own segmented bond market. Many efforts have been made to encourage more traditional issuers in the CIBM to issue bonds in the exchange markets, trying to bridge the valuation, liquidity and variety gaps between the two bond markets, and, at the same time, making securities information disclosures more open and public leveraging the advantage of the exchange system. Past experience does reveal that securities disclosures on exchange-traded bonds, such as basic securities information, price discovery, securities documentation and relevant corporate announcements, are more readily accessible and available. Shifting OTC trading to exchange trading for the securities market and centralising settlement & clearing have been a long-term goal of the financial market, and China has actually done a great job in those areas, largely owing to the relatively-youthful nature of the China’s securities market that has learned a great deal from developed markets’ experience. On this basis, we are hoping the Mainland-HK Bond Connect will help China to continue the efforts in that direction, i.e. integrating its multi-platformed bond market and making the market more centralised and exchange-style oriented. Another long-term issue is the future development of China’s credit bond market. The CIBM is dominated by treasury and other high-quality bond products that are largely considered interest rate products by market participants. In contrast, the exchange bond market is mainly made up of credit bond products, including corporate bonds, HY bonds and convertible bonds. Policymakers have been promoting the important function of direct finance for the economy in order to lessen the traditional heavy reliance of the economy on bank loans. That means China needs to greatly expand the corporate and other credit bond markets. In other words, the country needs to scale down the dominance of banks and other financial institutions in the CIBM, in order to make room for corporates and other credit entities to grow in the CIBM, as well as in the exchange bond market. Since the bond connect will initially open up the CIBM only to international investors, such a set-up would channel the investment flows into that market exclusively. Such an exclusivity would only further exacerbate the dominance of the CIBM in the China bond market and therefore the dominance of the financial bond segment. This could only disserve the market’s long-term needs and the trend of transitioning from OTC trading to centralised trading and from bank finance to direct finance. A long-term prospect With the rapid development of Fintech, including big-data technology, cloud technology, mass-sharing technology, artificial intelligence (AI) technology, mobile device technology, etc, the global financial market is facing revolutionary challenges to its traditional business practices and operation methodologies, and the bond market, which is the most diverse, complicated, structured and fragmented securities market, has a high probability of seeing the breakdown of some old conventions and breakout of new trends. The China bond market as a whole and the Mainland-HK Bond Connect in specific are well positioned to journey from tradition towards the future. It would be truly challenging for the policymakers and the market participants to make the “Mainland-HK Bond Connect” a long-term success and a globally-significant initiative.

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Steve Wang and Zoe Chuang: The "Half-Opened" Mainland-HK Bond Connect

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