China: Bond Connect is not what people think

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The differences between two landmark access programmes for China’s capital markets need to be understood.

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We don’t want to be churlish about an important landmark in the opening of China’s capital markets, but we keep hearing people talk about Bond Connect as a fixed income equivalent of Stock Connect. It isn’t, quite, and the market would do well to understand the nuances.

Clearly, both programmes exist to provide ease of access and reduce frictional costs for mainland Chinese assets and international investors through Hong Kong. It is also true that both will ease the inclusion of these domestic securities into international benchmarks, as is already happening with A-shares being added (in modest form initially) to key MSCI indices.

But let’s focus for a moment on the key differences. The most obvious is that retail can’t play in Bond Connect; whereas they have jumped on the opportunity to access Shanghai and Shenzhen stocks through Stock Connect, Bond Connect is institutional only for the foreseeable future. 

Also, this channel is northbound only: it is not a loop like Stock Connect. The opening of the southbound channel will depend very much on China’s attitude to capital flight, which it has been trying to moderate for the last 12 months.

The next difference relates to market infrastructure. Stock Connect clearly links Hong Kong and Shanghai infrastructure: exchange to exchange, clearing house to clearing house, depository to depository. But Bond Connect, by virtue of the fact that most bonds offshore are traded over the counter, does not have the same links. There is no exchange to link to and no clearing house either, since China’s interbank bond market doesn’t have central clearing, so it’s just the depositories that are linked. 

Counterparty risk

This therefore raises questions about counterparty risk and it means that the investor is not facing a Hong Kong broker as they would in Stock Connect, but dealing bilaterally with an onshore counterparty. Dispute resolution, therefore, is not going to be as simple for an international investor as it is in Stock Connect. Jurisdiction will probably be the mainland. And that, in turn, creates a need for due diligence on the onshore counterparty.

This isn’t the end of the world. In fact, it is probably a business opportunity for international banks like Citi, Standard Chartered, HBSC and BNP Paribas as market makers, since international clients worried about counterparty risk may gravitate to international names.

There are other differences. The People’s Bank of China (PBoC) requires full transparency from end to end in a way that is not the case with Stock Connect; institutional investors will have to register individually with China’s Foreign Exchange Trade System, under the PBoC.

On the positive side, Bond Connect has no mention of daily limits or quota like Stock Connect does. And everyone sees this as a positive step, one that is likely to lead to the eventual inclusion of Chinese bonds in the true benchmark indices rather than contrived variants of them as is the case today. 

UBS expects that if Chinese bonds gained entrance into the Citi World Government Bonds Index and the Bloomberg-Barclays Global Aggregate Index with a 5% to 6% weighting, passive inflows would be $200 billion to $300 billion in the near term, plus a further $20 billion to $30 billion if China is added to JPMorgan’s Government Bond Index-Emerging Markets at a 10% capped weighting. And that doesn’t count positions taken by active funds. 

But there needs to be a period of reflection while investors work out what Bond Connect is and what it isn’t. A large part of that process will be gaining confidence in counterparty risk in a way that simply doesn’t apply to Stock Connect investors.