E Zhihuan: Opportunities and Challenges for China's Bond Market Opening in the New Era

2018-02-06 IMI

E Zhihuan, Member of IMI Academic Committee, Chief Economist, Bank of China (Hong Kong) In 2017, the Ministry of Finance (MoF) issued USD 2 billion and RMB 14 billion sovereign bonds in Hong Kong, with an aggregate annual issuance at about RMB 28 billion. The issuance of dollar sovereign bonds in Hong Kong will increase the types of bonds in offshore markets, providing more high quality asset varieties to international investors. In the meantime, the issuance of dollar bonds facilitates the establishment of pricing benchmarks for foreign currency-denominated bond issuance and optimizes the yield curve, providing references to Chinese enterprises which raise funds in global financial markets. It would be conducive to developing multi-level capital markets, as mentioned in the 19^th CPC National Congress Report, by maintaining adequate issuance of multi-currency bonds in offshore markets, making the bond market the main battlefield for further financial opening. I. Significant progress in China’s bond market Fixed income is the most sizable asset class in global financial markets, and bonds are very important investment assets. As of the end of 2016, global bond market capitalization was approximately USD 100 trillion, compared with global equity market capitalization of USD 67 trillion. As of end-September 2017, bonds in custody in China amounted to RMB 71.9 trillion, of which interbank bond market amounted to RMB 63.7 trillion. China’s bond market is the third largest in the world, following the US and Japan. Both issuanceand transaction amounts in the interbank bond market account for almost 90% of the entire Chinese bond market. In 2016, bond issuance in the interbank marketamounted to RMB 32.2 trillion with annual transaction amount of RMB 127 trillion. In the first nine months of 2017, issuance and transaction amounts were RMB 28.1 trillion and RMB 73.8 trillion, respectively. In terms of relative scale, China’s bond market capitalization only accounted for 85% of GDP in 2016, far lower than the ratio of 210% for the US. The market capitalization and transaction activity of China’s interbank bond market have approached or reachedthe levels in major markets in Europe and the US. Nevertheless, the market is still immature. It is necessary to open the market at a faster pace by attracting offshore investors and issuers, optimizing market functions and enhancing the efficiency of allocation of funds, in order to better support the real economy. II. Analysis on bond market opening 1. Offshore markets take a leading role in China’s bond market opening At the initial stage of RMB internationalization, central banks, sovereign wealth funds and international monetary institutions around the globe mainly allocated in RMB assets in offshore markets. Before the RMB joined the SDR, nearly 30 sovereign institutions publicly announced to purchase RMB assets in offshore markets. RMB sovereign bonds issued by the MoF in Hong Kong were mainly sold to central banks overseas. Moreover, the UK Government and the British Columbia Provincial Government of Canada have issued RMB bonds in offshore markets, respectively. Offshore markets once took a leading role in China’s bond market opening, paving the way for RMB internationalization. The scale of RMB-denominated international bonds expanded after the RMB joined the SDR in 2016. The issuance of Panda bonds in onshore markets surged, whereas the issuance of Dim Sum bonds declined. The issuance of Dim Sum bonds in 2016 came in at merely half of the size in the previous year. 2. Onshore bond market opening has great potential China’s bond market opening has deepened since 2005. The Chinese Government progressively authorized international development institutions to issue RMB bonds in the onshore market, allowing Qualified Foreign Institutional Investors (QFII) and Renminbi Qualified Foreign Institutional Investors (RQFII) to invest in the interbank bond market, expanding the scope of eligible offshore institutional investors to various financial institutions such as commercial banks, insurance companies, etc. and other medium-to-long term investors authorized by the People’s Bank of China (PBOC). In July 2015, the PBOC authorized overseas central banks, supranational institutions and sovereign wealth funds to enter the interbank market after registration. They could conduct bond trading, bond repos, bond lending, forward bond agreements, interest rate swaps, forward rate agreements, etc. without limitation on investment scale. China’s bond marketcapitalization is more than USD 10 trillion, but the holding of RMB bonds by offshore institutional and retail investors was RMB 974.145 billion, accounting for 1.3%. This proportion was far below the ratio of 39% for the UK, 45% for Germany and 28% for Malaysia. The share of offshore investors in China’s bond market still has room for growth. 3. New progress in mutual bond market access The Bond Connect was officially launched on July 3, 2017, providing a convenient platform for offshore investors accessing the onshore market. The Bond Connect helps attract additional capital inflows to Hong Kong while furthering China’s bond market opening and the degree of internationalization. Under the Bond Connect model, offshore investors can directly place orders with authorized price-quoting institutions in China through global bond trading platform such as Tradeweb. The need for linking investors is now replaced by the connection between platforms. The Bond Connect adopts international law and regulatory standards, making overall transactions more convenient. Under the current mechanism, the operations of funds settlement and bond custody take place in Hong Kong. The Central Moneymarkets Unit (CMU) of the Hong Kong Monetary Authority (HKMA), being a nominee holder of the bonds, represents overseas investors to complete the procedure of funds settlement and custody through the nominee holding arrangement. Such operation simplifiesthe procedure of investing in the onshore interbank bond market for offshore investors, as they do not have to open bond custody accounts or funding accounts in China. The Bond Connect enhances the attractiveness of bond markets in Hong Kong and China. For one, it is able to meet the demand for bond market opening in China. For another, it solves the problem of different transaction approaches by offshore investors, promoting the development of the two financial markets consistently and steadily. Investors of the Bond Connect are institutional investors, including overseas central banks, financial institutions, etc. They invest in all types of bonds available in China’s interbank bond market (CIBM) without limitation on quota. Compared with the existing approach of offshore institutional investors participating in CIBM, the review period under the Bond Connect can be shortened with lower transaction costs. The increasing demand for RMB assets by offshore investors can be satisfied following the simplification of relevant procedures in the onshore bond market, expanding the scope of investment assets and issuers, improving financial infrastructure such as cross-border clearing and custody system. According to data from Shanghai Clearing House, in July 2017, settlement through the Bond Connect was RMB 1.4 billion with 32 transactions per week on average. Trading from offshore institutions was active. In August, offshore institutions increased holding on interbank deposits by RMB 27 billion through the Bond Connect, accounting for 40% of the entire increment. At present, nearly 60% of interbank deposits are conducted through traditional channels, such as CIBM and the QFII. III. New opportunities for China’s bond market opening in the New Era 1. A new phase of China’s economic development provides tremendous room for bond market opening China’s economy is entering a new phase of development, focusing on changing growth model, optimizing economic structure, transforming economic driving forces, establishing a modern economy, shifting from high rate of growth to high quality economic development, emphasizing quality and efficiency of economic development and macro policies, converting the focus of reform to improving intellectual property system and liberalization of production factors. The National Financial Work Conference has initiated to develop multi-level capital markets, as well as assigning an important role to direct financing. Against this backdrop, the bond market becomes more important in China’s financial system. The development and opening of the bond market are crucial to optimizing financial market structure and strengthening competitiveness of China’s capital markets. Moreover, such moves helpexpand the direct financing channels for enterprises and the real economy, converting the social financing structure which relies heavily on the banking system. It is able to solve some problems, such as rapid accumulation of debts and vulnerable financial systems, to a certain extent. In addition, the transmission of policy effects on the real economy can be more efficient. 2. RMB internationalization needs support from bond market opening Historical experience reveals that successful currency internationalization is supported by a sizable economy and merchandize trade volume, as well as robust and well-functioning financial markets. Following the inclusion in the SDR in October 2016, RMB internationalization is driven by domestic market developments. To enhance the global reserve currency function of the RMB, it is essential to be supported by offshore financial markets and matured onshore capital markets, providing international investors with more varieties of financial assets, convenient transaction channels and ample market liquidity in the onshore market. Holdings of the RMB by central banks around the globe keep increasing. As of the third quarter of 2017, the claims in the RMB were USD 107.94 billion, up 18.9% from the end of 2016. The RMB’s proportion of global foreign-exchange reserves was 1.1%, which was largely stable compared with the previous quarter. 3. The Belt and Road Initiative provides new opportunities for China’s bond market opening The 19^th CPC National Congress Report mentioned promoting market opening in both inward and outward directions, innovating approach on overseas investment and facilitating collaboration in global production with the Belt and Road Initiative as an entry point. The Belt and Road Initiative plays an important role in formulating a comprehensive market opening. The Belt and Road countries have great demand for funds. The Asian Development Bank estimated that cumulative investment for infrastructure projects in 5 ASEAN countries along the Belt and Road, China, Kazakhstan and Pakistan would be USD 5.7 trillion between 2010 and 2020. According to a report by Baker McKenzie, a law firm, and Silk Road Associates, the Belt and Road-related projects are estimated to be worth USD 350 billion over the next 5 years. The existing financing model is insufficient to support economic development, given low saving rate in some countries along the Belt and Road, immature financialmarkets, etc. As a result, it is essential to expedite the development of financial markets along the Belt and Road countries. Supranational institutions such as the Asian Infrastructure Investment Bank, the Silk Road Fund, etc., have providedfinancial supports to projects along the Belt and Road countries. Major financialinstitutions, such as Bank of China, are also rapidly developing a financing network. They supported the construction of local projects by providing syndicated loans. Furthermore, the degree of bond market development is crucial for promoting the usage of funds along the region. IV. New Challenges for China’s bond market opening 1. Offshore investors remain sceptical about entering China’s bond market For the time being, major investors in China’s bond market include commercial banks, credit unions, securities firms, investment funds, insurance companies, non-financial institutions, etc. In terms of bond holdings, commercial banks take the lead with over 60% of market holdings, while other types of institutions have relatively low shares. As RMB internationalization progresses, offshore investors are becoming important participants in the bond market. The holding of bonds and equities by non-residents is responsive to the degree of China’s capital account opening. Asset holdings by offshore investors will increase following the ease of relevant policies. It will be more convenient for overseas investors to increase their holdings of RMB assets with more investment channels. However, offshore investors have three concerns about entering China’s bond market. The first concern is about the free movement of funds. The second concern is about insufficient secondary market liquidity due to the lack of depth of the bond market. The third concern is about an incomprehensive credit rating system, as credit agencies do not completely meet international standard. For example, the credit ratings for corporate bonds cannot fully reflect the implied risks. 2. The progress of market opening in both directions is affected by capital outflow pressure and expectation of RMB exchange rate Financial risk control is a priority as mentioned in the Central Economic Work Conference, to ensure the prevention of systemic risks. The RMB’s exchange rate has stabilized since 2017, given the week dollar, expectation management by the PBOC, the improving Chinese economy and supports from macro policies. The RMB is expected to be stable and the condition of capital outflow is manageable. Against this backdrop, the bond market could open further by expanding the Bond Connect from Northbound Trading to Two-way Trading in due course. For one, the Northbound Trading corresponds to the principle which encourages capital inflow and controls capital outflow at the same time. For another, the introduction of the Southbound Trading will be determined by a number of factors, such as changes in the balance of payments, capital flows between onshore and offshore markets, etc. 3. The bond market’s lack of depth and breadth constrain the progress of market opening Capital market opening in both directions can shortenthe review period with lower transaction costs. Moreover, it can attract different offshore investors, making a breakthrough in product diversification and primary market development in China’s capital markets. In addition, it can enhance the adaptability to regulatory environment, taxation and legal framework. The bond market depth and breadth can be enhanced given simplifying procedures in onshore capital markets, expanding the scope of investment assets and issuers, improving financial infrastructure such as cross-border clearing and custody system, which satisfies the increasing demand for RMB assets by offshore investors.

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E Zhihuan: Opportunities and Challenges for China's Bond Market Opening in the New Era

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