Guarded optimism over 'Bond Connect' between Hong Kong, mainland
Market players in wait-and-see mode amid lack of key info
JOYCE HO, Nikkei staff writer
HONG KONG -- As part of China's push to internationalize its currency and fledgling capital market, a new channel for foreign investors to access its $9 trillion onshore debt market through Hong Kong was unveiled late Tuesday. But a long wait is expected until the so-called Bond Connect gets off the ground, with the sketchy implementation details and premature market conditions having created overwhelming uncertainties for market participants.
The new program, the latest step in the liberalization of the world's third-largest bond market, is predated by the Qualified Foreign Institutional Investor program established in 2002, the Renminbi Qualified Foreign Institutional Investor program of 2011, and the China Interbank Bond Market direct-access scheme of February 2016.
For the first time, overseas investors will be exempt from direct engagement with onshore Chinese regulatory authorities, as all transactions will be settled through the Hong Kong Monetary Authority's Central Moneymarkets Unit, while orders will be placed through an electronic platform run by Hong Kong Exchanges & Clearing.
Unlike the current equity market mutual-access program, funds under the Bond Connect will initially flow only to the mainland, in so-called northbound trading, with an unlimited quota.
While market observers generally welcomed the initiative, first announced by the Chinese premier Li Keqiang upon the National People's Congress in March to show support for Hong Kong, many express concern about the dearth of details. Cindy Chen, who heads Citibank's securities services in Hong Kong, noted that operational complexity had held investors back from entering the Chinese market previously, despite anticipation for the ascendance of the Chinese yuan, which was added to the International Monetary Fund's Special Drawing Rights basket in 2015. "There is interest, it's just that action has not followed that level of interest yet," Chen said.
Judging by Tuesday's joint announcement from the People's Bank of China and the HKMA, such key specifics as the ownership structure, the chain of custody, account openings, procedural flows, tax arrangements, and even the precise launch date remain up in the air.
First and foremost, investors are confused about whether their investment income needs to be taxed in China and how such taxes should be paid, PricewaterhouseCoopers tax services partner Lee Puay Khoon told reporters Wednesday.
"Technically, there is a withholding tax liability but there is no mechanism for foreign investors to pay the tax," said Lee, referring to the China Interbank Bond Market direct-access scheme announced in February 2016. "It would be good if the [People's Republic of China] tax authority would actually issue a circular to confirm the tax treatment."
Another concern is the relationship between multiple channels that investors can now use for accessing the bond market. "A big project for the PRC regulator is how to coordinate between different channels," said Ge Yin, counsel at Clifford Chance, who points out that investors that have already entered the China market through earlier but more cumbersome channels might feel disadvantaged if their previous positions cannot be consolidated with the new, apparently more user-friendly Bond Connect channel.
"We would really like the authorities to provide some sort of consultation and a sufficient grace period for the industry to implement because I think a number of issues need to be clarified," said Sally Wong, CEO of the Hong Kong Investment Funds Association, citing withholding tax treatment and beneficial ownership among many issues.
Currently, Beijing is hoping that reducing operational complexity in the largely over-the-counter market will help enhance the appeal of Chinese bonds for possible inclusion in global indexes.
HSBC sees the potential inclusion in J.P. Morgan's Government Bond Index-Emerging Markets possibly meaning a potential flow of $18 billion to 20 billion into China government bonds, assuming that a 10% permissible weighting for a single sovereign would be applied. Separately, a 5% weighting for China bonds in Citi's World Government Bond Index and World Broad Investment Grade Index would translate into potentially $200 billion in portfolio investment.
Byran Collins, fixed-income portfolio manager at Fidelity International, believes that fresh flows will mainly be plowed into such high-quality credit as government bonds and that implicitly guaranteed by the government, such as Tier 1 state-owned enterprises' issues, as well as policy and commercial bank papers. "For now, we are not talking about accessing the very low quality credits because, in part, a lot of them are quite small issue size and perhaps they are not very liquid," Collins said. "They actually represent a small part of the investment universe."
However, some observers believe that China bonds' global appeal is weak. "We doubt it will make a big difference to demand for Chinese bonds, at least in the near term," said Mark Williams, chief Asia economist at Capital Economics, of the Bond Connect. Williams noted that yuan-denominated bonds so far account for just 1.1% of global foreign exchange reserves.
Topping investors' concerns are yuan depreciation, weak liquidity, and a murky credit-grading system out of sync with those of international ratings agencies. A wider range of symbols or grades "would help investors differentiate credit quality more," said Angus Hui, fund manager for Asian fixed income at Schroder Investment Management, who noted the majority of Chinese bonds are rated AAA, AA-plus and AA. Additionally, he is wary that China's bankruptcy regime is still not tested due to Chinese companies' lack of option to default.
Since August 2015, persistent depreciation by the yuan has deterred investors from buying yuan-denominated bonds, as reflected by the reduction in yuan-denominated transactions in the offshore market. The total volume of Chinese corporate and financial dim sum bonds -- bonds denominated in the offshore yuan -- declined 50.9% on the year to $6.79 billion in 2016, whereas dollar bond issues surged 21.9% to $103.41 billion, data from Dealogic shows. Year to date, the former fell 80.5% compared to the previous year to $488 million, whereas the latter almost tripled to $74.8 billion.
The strong tendency of Chinese issuers to tap the offshore bond market against deleveraging sentiment at home has also led Bank of America Merrill Lynch to upgrade its forecasts of dollar bond issues in Asia this year from $178 billion to $215 billion.