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The Bond Connect facility launched in July 2017 makes it even easier for foreigners to buy Chinese bonds than was previously expected.  The new scheme’s efficiency greatly boosts the likelihood of China bonds being included in leading emerging-market bond indices and, eventually, into global bond indices.

Bond Connect follows the Stock Connect links forged between the Hong Kong and Shanghai stock exchanges and subsequently the Hong Kong and Shenzhen exchanges. It provides a fourth channel for foreign institutional investors to purchase onshore China bonds, augmenting the existing China Interbank Bond Market (CIBM) scheme, the Qualified Foreign Institutional Investor system and the Renminbi Qualified Foreign Institutional Investor scheme.

One key advantage of Bond Connect is that, unlike the CIBM scheme, foreign investors need not adhere to investment quotas or file details of their intended investment size. The other existing schemes are all based on investment quotas.

Further, bonds bought through Bond Connect are held in custody with the clearing system operated by the Hong Kong Monetary Authority. Foreign investors can thus appoint global or local custodians, whereas the existing schemes require offshore investors to set up accounts with onshore custodians.

Also, investors can use offshore renminbi or foreign currency that can be converted at an approved Hong Kong bank with access to the onshore renminbi market. Portfolio managers thus avoid exposure to currency risks.

And unlike the existing schemes, Bond Connect does not require transactions to be pre-funded. If a transaction does fail, the investor’s funds stay in Hong Kong.

Some 20 onshore banks and securities companies have been selected to provide bond pricing. A trading platform is in place for sending dealing instructions and trades are recorded in the China Foreign Exchange Trading System. More international trading platforms can be incorporated later.

The settlement period for the onshore China bond market has also been lengthened from same-day or next-day settlement to two days after the trade. This makes it easier for foreign investors, particularly Western firms, to buy onshore bonds. This extended period will also now apply to the existing schemes.

Of course, there is always room to do better. Interest-rate hedging with onshore rate swaps is not permitted with Bond Connect but is possible under the CIBM scheme. Hopefully that will change.

But given that Bond Connect has improved the accessibility of onshore China bonds, we are more optimistic about them being included in leading bond indices, especially the emerging-markets index. Given the huge amount of outstanding Chinese government bonds, China could warrant the maximum permitted 10 per cent weight for a single sovereign issuer.

With around USD200 billion of funds tracking the leading index, inclusion could mean flows of about USD20 billion into China government bonds. Joining global bond indices would be even more significant: a 5 per cent weight would translate into around USD200 billion of portfolio investment demand.

So, taken together, China could receive around USD250bn of bond inflows over the next two years if the Bond Connect takes off successfully. This could lift the foreign ownership ratio of China’s central-government bonds from 3.9 per cent currently to 15 per cent in 2020.

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