A recent surge in investment volume under the Southbound leg of the China-Hong Kong Bond Connect scheme has been driven by rising mainland interest in offshore renminbi notes, but a further relaxation of the scheme's volume cap is unlikely to happen in the near term given Beijing’s concerns about capital outflows.
The Southbound leg, which allows onshore Chinese investors to buy bonds issued and listed in Hong Kong, celebrated its one-year anniversary on September 24. While that link, which followed the Northbound route launched in July 2017, had been touted by Beijing as a game-changer and a way for the Chinese capital market to deepen its connection with Hong Kong, it initially found only a tepid response.
As of March, only 61 bonds were under the Southbound scheme custody with a total investment balance of Rmb16bn (US$2.3bn), compared with 35 notes and a balance of Rmb5.53bn in September 2021, according to the Shanghai Clearing House, the primary custodian for mainland investors who participate in the scheme.
But the situation has changed, with mainland money flowing into Hong Kong’s bond market via the Southbound leg surging in the past few months. As of the end of August, there were 437 bonds under custody with a total balance of Rmb301.45bn, up 1,784% from the balance in March.
Mainland investors are mostly snapping up CNH-denominated bonds, otherwise known as Dim Sum notes, bankers said. Demand for US dollar notes is limited because they are more complicated to settle, said a DCM head from one of the 13 market makers that act as intermediaries between onshore investors and the Hong Kong bond market under the Southbound leg.
“Onshore investors naturally have more renminbi liquidity than that for US dollar, and they look for arbitrage opportunities in CNH notes,” said the banker. Prior to the launch of the Southbound leg, onshore investors needed to use CNH deposited offshore to buy the notes, but under the scheme they only need to register with the People’s Bank of China and get a quota for investing in Hong Kong.
"The rising onshore participation will definitely help the CNH bond market grow much faster and liquidity become much deeper for both cash bond and funding markets," said Edward Pan, China macro strategist at Standard Chartered, another market maker under the Southbound leg.
The yield differential between onshore and offshore notes due to the diverging monetary policies in China and the US has been driving onshore investors to look for better returns in Dim Sum bonds. While the Federal Reserve raises rate to combat rising inflation (and Hong Kong raises its rates because its currency is pegged to the US dollar), Beijing has been cutting rates in a bid to spur the economy, which has been deeply wounded by the country’s zero-Covid policy.
“Economic fundamentals have been consolidating onshore, while the People’s Bank of China has been cutting rates, so the onshore rates have been going lower and lower, while for CNH yield it's more driven by the global environment,” said Gary Lo, head of onshore China trading at Credit Agricole.
Onshore investors are mainly chasing names including the foreign branches of Chinese banks, and focusing on offshore certificates of deposit, which have higher rates than their onshore equivalents, according to Lo.
The rising investor interest from the mainland has supported a booming Dim Sum market this year, with the gross proceeds reaching US$33bn from 357 issuances as of September 30, according to Refinitiv data. The number of Dim Sum issues and total deal volume in the first nine months of 2022 have surpassed the full-year totals in each of the past four years.
The growing activity under the Southbound leg meanwhile means the Rmb500bn annual quota is being used up quickly. Many investors hope Beijing will increase the annual cap to allow more participation, given the Northbound leg does not have any annual or daily trading cap. Between January and August, the trading volume under the Northbound leg reached Rmb5.3trn, with average daily turnover standing at Rmb31.8bn.
But the chance of Beijing adjusting the quota for the Southbound leg is low near term given the elevated depreciation pressures on the renminbi and concerns around capital outflows, said Pan at Standard Chartered.
Likewise, Beijing may be slow to increase the number of investors eligible to participate in the Southbound link. As it stands, only 41 Chinese banks, including policy and state-owned firms, as well as investors under the Qualified Domestic Institutional Investor scheme and its renminbi-denominated version the Renminbi Domestic Institutional Investor scheme, can participate in Southbound trading.