bond-aid for RMB

RMB internationalisation

The northbound link of the long-awaited bond connect will likely be launched 1 July 2017, allowing foreign investors to trade onshore bonds without investment quotas or onshore accounts. This is the latest move in the central bank's (PBoC) two-year campaign to open the onshore bond market, part of its broader agenda to promote RMB internationalisation. The medium-term aim is to get Chinese bonds included in global benchmark bond indices, as Zhou Xiaochuan 周小川 PBoC governor stated in March 2017. Inclusion in the main indices, expected within three years, could attract potential inflows of US$250-300 bn, according to Morgan Stanley.

directing debt

Increasing investment into the onshore bond market is critical, as the government moves away from indirect financing through banks, towards direct financing through bonds and stocks.

The onshore bond market is set to become the second largest in the world by 2020, equivalent in size to 100 percent of GDP or C¥95 tn. C¥24 tn in bonds were issued in 2016 alone. In 2014, C¥15.4 tn in local government debt, in the form of bank credit, was authorised to be swapped into bonds by 2018. Enterprise bonds grew by C¥4.45 tn from March 2014 to March 2017 following State Council’s call for more direct financing. Policy bank credit bonds grew by C¥3.37 tn in the same period.

For all its size and rapid growth, China's bond market is notorious for chronic structural issues, including market segregation, low liquidity, a homogeneous investor base, and implicit state guarantees, all of which undermine its market appeal (see table comparing interbank and exchange bond markets). Fragmentation into interbank and exchange markets, supervised by different regulators, compromises the price-discovery function. With banks, the majority investors, generally holding bonds to maturity, liquidity is low in the secondary market. China’s credit rating system is also undeveloped.

More foreign investors, with different strategies and portfolios, would diversify the investor base. By bringing in international credit rating institutions, PBoC hopes to foster a much-needed credit culture. Finally, foreign capital would ease pressure on domestic banks, which are struggling to buy enough bonds to keep local government debt swaps on track.

outlook

PBoC’s forex reform strategy, encouraging inflows while curbing outflows, remains in place, which will limit the connect's effectiveness. With RMB devaluation fears looming large, capital controls will likely stay, restricting repatriation of funds and dampening foreign investment. Secondly, while the bond connect‘s smoother infrastructure may attract more institutional investors, they will be mostly smaller players seeking relatively minor exposure. Major foreign investors already have direct access to China’s bond market (see table latest regulations on foreign investors in the interbank bond market).

However, China's bond market provides global investors a valuable investment alternative. PRC government and financial bonds are almost risk-free, due to state backing, isolating them from international crises and domestic turbulence. Yields are consistently one percent above US bonds. RMB devaluation fears may be overstated: the RMB is more stable than many other emerging and developed countries’ currencies. Prominent initiatives, like the Shanghai–London Stock Connect under negotiation, would help raise brand recognition, and tailor financial products to investors’ needs.

PBoC will continue to promote bond market reform under the framework of RMB internationalisation. Closer integration of regulatory agencies, heavily foreshadowed in 2015, appears to be off the cards for the time being. But integrating supervision over transactions is underway. Technical issues, like full ownership of securities accounts, can be addressed quickly. Bigger changes may need to wait till the fifth central financial work conference in late 2017. Legal protection of close-out netting, an established global settlement practice, may depend on revising Securities Law or Bankruptcy Law. These reforms may speed up if local bonds are included in main bond indices, giving PBoC more leverage to push its agenda.

profiles

Zhou Xiaochuan 周小川 | PBoC governor

Central bank governor since 2002, Zhou, likely soon to retire, has established himself domestically and internationally as a pragmatic yet charismatic reform-minded bureaucrat. Zhou is often under-appreciated by outsiders, having made significant moves to liberalise interest rates: he removed the floor on lending in 2013, and the ceiling on deposit interest rates in 2015. In that year, he also set up a deposit insurance scheme, protecting depositors for up to C¥500,000 in cases of commercial bank bankruptcies. Aiming for a 'dirty float' regime for RMB (proposed in 1993), Zhou takes every opportunity to tell the international community the state will keep its hand on the tiller. He has made it clear the bond connect initiative is about inclusion in key indices.

Li Keqiang 李克强 | premier

If Charles Li, the Hong Kong Stock Exchange chief executive, is the HK face of the bond connect, Li Keqiang is its mainland face, and he used the high-profile Two Sessions to publicise the new initiative. Seeking to preserve Hong Kong’s position as the gateway to the mainland financial market, the bond connect was in his gift package to the newly elected Hong Kong Chief Executive-designate.

Pan Gongsheng 潘功胜 | State Administration of Foreign Exchange (SAFE) director; PBoC vice governor

Vice governor since 2012, Pan’s appointment as the director of SAFE at the start of 2016 surprised many, given his lack of forex experience, though the media point to his ability to communicate with international audiences in English. China, he insists, will not engage in a currency devaluation war. PBoC has since August 2015 constantly intervened in the forex market in a bid to prop up the RMB, he says, providing liquidity, and attenuating excessive adjustments and herd effects. The international community, says Pan, benefits from China's increased forex flexibility and RMB stability. Fine tuning accounting, auditing, tax, and credit rating rules will continue, says Pan, to make them fit international standards.

context

interbank bond market opening

17 May 2017: commentators call for details on the northbound link

17 May 2017: PBoC and HKMA jointly announce the bond connect; northbound trading will come first, enabling overseas investors to trade on the interbank bond market under the current policy framework for overseas mid- to long-term participants without quotas or product limits

12 May 2017: China opens the credit rating market to international agencies and grants JP Morgan and Citibank licences to sub-underwrite and settle in the interbank bond market

10 Apr 2017: MoF issues first offshore government bond futures contract on Hong Kong Exchanges (HKEX) to help investors hedge against risks, but receives lukewarm responses from investors  

7 Apr 2017: Shanghai Clearing House hosts a conference with Toronto TMX, discussing financial infrastructure interconnectedness and cooperation

2 Mar 2017: China Central Depository & Clearing Co Ltd signed MoU with Clearstream on infrastructure collaboration. CCDC is where all foreign institutions are registered with their holding under the custodian. Clearstream is an international settlement and custody organisation, offering services for domestic and cross-border equities, bonds and investment funds  

27 Feb 2017: SAFE issues ‘SAFE Huifa [2017] No. 5’, further opening the interbank derivatives market for overseas investors for currency risk hedging

5 Sep 2016: PBoC and SAFE jointly issued Yinfa [2016] No. 227, levelling controls on RQFIIs with QFIIs in terms of lock-up period and fund repatriation

27 May 2016: SAFE issues ‘Huifa [2016] No. 12 to implement “PBoC Announcement [2016] No. 3”’; removing patriation restrictions on QFIIs, foreign investment remittance will be subject to only the same currency ratio as funds were originally remitted into China, with 10 percent flexibility; this policy gives great advantage to other investors outside the QFII and RQFII programs

24 Feb 2016: PBoC issues ‘PBoC Announcement [2016] No. 3’, facilitating investments by long-term institutional investors in the interbank bond market, including commercial banks, insurers, securities firms, and funds and other asset managers. This streamlines procedures and removes quotas, and subjects investors to macroprudential management; forex quotas were also substantially increased

4 Feb 2016: SAFE issued SAFE Announcement [2016] No. 1, reducing controls over QFIIs. The investment principal lock-up period was reduced from one year to three months, while still subjecting accumulated monthly net capital repatriation to 20 percent of total onshore assets as at previous year end

30 Sep 2015: PBoC issues ‘PBoC Announcement [2015] No. 31’, opening the interbank forex market to central banks and monetary authorities, international financial institutions, and sovereign wealth funds

14 Jul 2015: PBoC issues ‘Yinfa [2015] No. 220’, opening the interbank bond market to overseas central banks and monetary authorities, international financial institutions, and sovereign wealth funds; these investors are subject to simplified procedures and unlimited quotas and products

3 Jun 2015: PBoC issues ‘Yinfa [2015] No. 170’, opening bond repurchase trading in the bond market to overseas RMB clearing and participating banks

10 Mar 2013: PBoC issues ‘Yinfa [2013] No. 69’, opening the interbank bond market to qualified overseas investors with limited quotas

16 Aug 2010: PBoC issues ‘Yinfa [2010] No. 217’, launching a pilot program to the interbank bond market; overseas central banks and monetary authorities, RMB clearing banks and participating banks are granted quotas to trade bonds; starting from RMB clearing and participating banks in HK and Macau, the pilot was later extended to more overseas banks

RMB’s path toward managed convertibility

21 Apr 2017: PBoC reportedly abolishes a January RMB cross-border settlement requirement on financial institutions to sell as much RMB as purchased on a monthly basis; the offshore RMB market suffers significantly as authorities crack down on overseas RMB used to hedge against RMB’s fall; this move reinstalls RMB internationalisation after the suspension in 2015 and 2016

31 Dec 2016: PBoC lowers threshold for reporting cash transactions, targeting cross-border flows 2

8 Nov 2016: the Shanghai branch of SAFE holds a meeting on capital controls

30 Nov 2015: IMF admits RMB into its SDR basket, a global elite reserve currency club, effective 1 Oct 2016

3 Nov 2015: CCP lays out 13th 5-year plan proposals, stipulating initiatives such as increasing two-way opening in financial sector; realising capital account convertibility orderly; pushing for RMB inclusion in SDR; reforming forex management and use from a positive to negative list; relaxing forex restrictions on foreign investment

11 Aug 2015: PBoC announces another round of forex reform, triggering a two-year long turmoil

17 Mar 2014: PBoC widens the RMB’s trading band to 2 percent

16 Apr 2012: PBoC widens the RMB’s trading band to 1 percent

July 2008: PBoC imposes a RMB forex scheme that essentially pegs it to the USD

21 May 2007: PBoC widens RMB’s trading band from 0.3 to 0.5 percent

21 Jul 2005: PBoC announces a managed-floating scheme based on market supply and demand, referring to a basket of currencies; depegged from the USD, the RMB strengthens by 2.1 percent against USD at 8.11

soon after 15 dec 1997: China announces the RMB will not devalue against the USD, starting an eight-year-long pegging to USD

14 Nov 1993: CCP lays out a market-based managed floating forex scheme and a gradual free convertibility path for RMB