Market participants long anticipating the launch of southbound Bond Connect may have felt a little deflated when the programme was finally announced. Initial quotas for Chinese investors to buy offshore bonds have been set at a very modest US$78bn annually, and US$3.1bn daily.
Nevertheless, China’s approach to capital markets internationalisation has always been gradual. The quotas will be raised over time, and longer-term opportunities will arise from the programme.
Some US$33trn of Chinese private wealth is held in low-yielding bank deposits, far exceeding investment in domestic stock and bond markets. Given the country’s rapidly aging demographic profile, Chinese policymakers need to raise savers’ allocations to higher-return assets to reduce the government’s future social welfare burden. China’s own markets are not yet deep enough to absorb so much capital, so the eventual scale of Chinese portfolio investment in global bond markets could be very sizable.
Private outbound portfolio investment, such as that through southbound Bond Connect, could help reduce current geopolitical tensions, since such investment raises fewer questions about Chinese government influence and technology transfer compared with foreign direct investment or takeovers by Chinese corporations.
Chinese investors are natural buyers of offshore yuan bonds, which will likely lead to more renminbi-denominated bond issuance by international corporates and governments. Notwithstanding relatively high renminbi interest rates versus the US dollar at present, those with large trade relationships with China, including many Asian governments and corporates, could find yuan issuance attractive as a way to better match their funding profiles with their trade exposures.
Growth in the offshore yuan market will also drive changes in China’s domestic financial system. Today, onshore Chinese bond yields are still significantly affected by state-owned banks’ dominance of the market, which tilts the scales in favour of government-preferred industries. Greater competition with the Dim Sum market should lead to more market-driven pricing and improved risk allocation in China’s domestic market. At the same time, as the Dim Sum market grows, it will become more difficult for the People’s Bank of China to manage the renminbi’s exchange rate.
Here, China could have significant mutual interest with its Asian neighbours in further developing local currency bond issuance in the region.
While Asian countries have looked to reduce reliance on foreign borrowing since the Asian financial crisis by developing local currency bond markets, many remain heavy users of US dollar funding markets. This exposes them to periodic bouts of dollar volatility.
Over the past two decades, Asian countries have built up substantial dollar reserves to protect themselves from sharp swings in their currencies versus the greenback. However, since US Treasuries have far lower yields than the local currency sovereign debt issued to sterilise these foreign exchange reserves, this is an expensive strategy. The consequent overvaluation of the dollar is also a continual source of geopolitical tensions. A more diverse funding mix would help, but switching from dollar to renminbi borrowing simply transfers the risks and systemic stress from one currency to another.
Chinese policymakers are acutely aware of the huge costs paid by US exporters and manufacturing workers due to the dollar’s dominant role in the global monetary system. They will therefore be wary of allowing the Dim Sum bond market to follow the precedent of unrestrained rapid expansion in the eurodollar bond market – though there are few ways to control an offshore market outside your jurisdiction.
One way for Chinese policymakers to mitigate the risks of overconcentrated expansion in the Dim Sum market would be to allow Chinese investors to buy regional local currency bonds, as product eligibility for southbound Bond Connect is expanded.
Growing intraregional investment in Asian securities markets will need appropriate quotas so as not to flood individual Asian markets with too much Chinese capital, and much work needs to be done on the ‘plumbing’ required to support such investment. The cross-border settlement arrangements between mainland China and Hong Kong have limited scope, while geopolitical tensions will limit China’s appetite to rely on western-controlled settlement and depository infrastructures.
A new platform will be needed to support Asian pan-regional settlement and securities safekeeping. Acceptance of Asian local currency sovereign bonds as collateral for short-term liquidity in international markets must be enhanced. New derivative instruments would also need to be created to support hedging between the renminbi and other Asian currencies. But the commercial opportunity is enormous.
More than simply another cross-border trading scheme, southbound Bond Connect could herald a brave new multipolar world in global bond markets. However, grasping that opportunity will require vision, long-term dedication, and investment in Asian regional financial infrastructure.
*James Fok is an experienced financial professional. He was previously a senior executive at Hong Kong Exchanges and Clearing, where he played a major role in establishing the Stock and Bond Connect programmes between Hong Kong and China, and prior to that worked as an investment banker in Europe and Asia. He is the author of the upcoming book Financial Cold War, published by Wiley.