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China 'bond connect' talk overlooks landmark market opening

Hundreds of foreign investors are already buying domestic interbank debt

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Shanghai-Hong Kong Stock Connect provides for mainland flows into Hong Kong-listed equities and allows overseas investors access to Chinese domestic shares.   © Reuters

Chinese Premier Li Keqiang has dangled a carrot for Hong Kong markets. At the press conference to close the annual National People's Congress session in Beijing on March 15, he floated a trial proposal to expand the Stock Connect link between Hong Kong and the stock markets of Shanghai and Shenzhen to include access to mainland bonds.

It sounded like a big deal. But while many international investors have yet to notice, Chinese authorities have already fully opened the country's bond market to foreign institutions. More than 200 investors have applied for access and are already trading the instruments.

Expansion of the Connect link has long been discussed, especially since the addition of Shenzhen-listed stocks in December. As 2017 marks 20 years since Britain returned Hong Kong to China, it is inevitable that mainland authorities will throw some freebies the territory's way.

While Stock Connect gave Hong Kong and overseas investors access to Chinese domestic shares, it also provided for mainland flows into Hong Kong-listed equities in return. What does Hong Kong have to offer under a "bond connect" link?

There is little bond market activity to speak of in Hong Kong, and what issues there are pale next to the scale of China's domestic interbank bond market, which has become the world's third largest after those in the U.S. and Japan. Hong Kong may still be a gateway to China but Hong Kong Exchanges & Clearing has a pretty meager offering of products to entice mainland investors and all the best ones are already accessible.

Stock Connect has been a bold and fresh development for inbound Chinese investment. It was the first platform that did not require any scrutiny of the suitability of investors: Any foreigner could invest. What a change from the past 20 years!

But such link ups are fundamentally limited in scope. Not all investment products trade on exchanges, and differences of time zone and holiday calendars make expansion beyond China even more problematic.

The big opening

Regardless of what Li was proposing and what eventually is rolled out, the opening of the Chinese interbank bond market has been frankly startling in its scope. The initial rules were announced in early 2016 with detailed provisions coming last May. Many viewed this as a desperate attempt to attract funds into China just as capital outflows were seemingly getting out of hand.

But the People's Bank of China proceeded to fully open the bond market to foreign institutions and applications to trade are being processed within a matter of weeks. Some investors have been surprised at how quickly their applications have been handled. Each needs to work with an onshore bank as an agent/custodian, and that bank is expected to act as a gatekeeper in accepting suitable investors for the interbank market. This is far less onerous that previous approval processes for entering China's markets.

Hong Kong bond connect may allow retail access to onshore bonds, something the People's Bank of China hasn't previously allowed, but frankly, that would be a sideshow. Overseas retail investors are not clamoring to buy Chinese corporate or government debt.

In January, the PBOC released a list of 239 central banks, commercial banks, brokers and fund managers that are now active in the interbank market. The PBOC must be pleased with how the list has grown so far.

Officials are clearly confident in opening the market -- no capital controls have been placed on cross-border money flows. On Feb. 27, they expanded the program further by allowing overseas institutional investors access to the onshore foreign exchange spot and derivatives markets to hedge the exposure generated by their interbank bond investments.

This bold opening, in spite of China's volatile markets last year, reflects well on PBOC Governor Zhou Xiaochuan. He helped develop a commercial paper market in China over a decade ago and he continues to push for openness and reform. Global investors have rewarded his move on bonds, with Citi adding Chinese domestic debt to its fixed income bond indexes.

The contrast with the opening of the equity markets and the reluctance of MSCI to include Chinese stocks in its indexes is startling. But the interbank move may serve as both a catalyst and a benchmark for what the China Securities Regulatory Commission needs to do to open up the equity markets further.

What of the bond market itself? For all the good work in providing access to it, the Chinese bond market remains a work in progress. As the debt story has come to the forefront in China, bond issuance has grown quickly, with a heavy flow of national and local government, corporate and policy finance bonds and certificates of deposits.

Yet the issuance level and trading volumes don't tell the whole story. The market remains dominated by large state banks that are mainly buy-and-hold investors. Liquidity in the corporate market can be very patchy and the vast bulk of issued products do not trade on any given day. The credit quality of issuers is a growing problem, and although defaults are growing, even among state-owned enterprises, few think that bond prices properly reflect credit quality in China.

Chinese financial markets are full of such gaps and imperfect solutions. The problem for foreign investors has been that they haven't able been able to access them and search out the good stuff. At last, the Chinese authorities have shown they can open their markets. Foreign participation won't cure debt market woes, but the interbank opening should be warmly welcomed and act as the benchmark for future developments.

Fraser Howie is co-author of "Red Capitalism: The Fragile Financial Foundation of China's Extraordinary Rise." He has worked in China's capital markets since 1992.

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