Global investors are getting ready for the inclusion of China’s onshore debt into international indices, with a focus on issues such as liquidity and hedging.

    The story of foreign participation in China’s onshore bond market is a long one - starting in 2002, when the Qualified Foreign Institutional Investor program (QFII) was launched. Since then, there have been several significant initiatives, each producing a new channel into the world’s third largest bond market. The China Interbank Bond Market (CIBM) Direct opened the door further in 2016, and more recently Bond Connect allowed for onshore access via Hong Kong.

    Index inclusion is the next development that will drive more foreign investors into Chinese domestic bonds. This trend started earlier in 2019, when Bloomberg started to include Chinese government bonds into its Bloomberg Barclays Global Aggregate index (BBGA) – one of the world’s most widely followed bond indices, tracked by assets worth approximately USD2.5 trillion.

    A lot of demand for Chinese onshore debt has come from central banks diversifying their reserves into renminbi assets – namely Chinese government bonds. Index inclusion will spur a wider range of investors into China, as investment managers from around the world will adjust their portfolios to track changes in the indices they use to benchmark their performance.

    The impact on China’s onshore market will be profound, said Andre de Silva, Head of Global Emerging Market Rates Research at HSBC. He was speaking at a panel focused on index inclusion at HSBC’s 2019 China Conference.

    A weighting of 6.1 per cent in the BBGA should result in inflows of around USD150 billion into the market, he said. It will also, he added, increase the level of ownership in a market that has traditionally been mostly held by local investors – as foreign owners hold just 8.1 per cent of China’s government bonds, compared to Indonesia and South Africa, which are both slightly under 40 per cent foreign owned.

    With China’s inclusion into the BBGA already under way, attention is shifting towards index providers that are expected to make a similar move. FTSE Russell is reviewing China’s potential entry into the FTSE World Government Bond Index (WGBI). Like BBGA, WGBI is also tracked by assets worth USD2.5 trillion, which again could lead to between USD125 to USD150 billion of inflows.

    An objective and transparent process

    Adding a new country to a large index can affect a wide range of parties – such as asset owners, fund managers, market makers, market infrastructure providers and regulators. “As an index provider, it is therefore very important for us to develop a common language to bridge the gap among all the key stakeholders so that they are all on the same page,” said Zhanying Li, Director of Fixed Income Indices, at FTSE Russell.

    She said that there has been a perception that the inclusion procedure is more opaque for bonds than it is for equities. FTSE Russell is making sure the inclusion process is as transparent as possible by following a structured framework. At FTSE Russell, the process is stakeholder driven and involves deep market engagement with substantial input from major stakeholders.

    The FTSE WGBI has three broad criteria for new country inclusion. The first two – size of the market and credit ratings – have been met by China, due to its scale and the quality of its credit. The area where there is still progress to be made is accessibility. “For foreign investors to track an index, they really need to be able to move money in and out of the market. They also need to be able do the necessary foreign exchange conversion and hedging, and they must be able to buy and sell the bonds as needed without excessive costs,” said Ms. Li.

    The FTSE fixed income inclusion framework is designed specifically for fixed income investors and is now aligned with the long-established equity framework from a governance perspective, said Ms. Li. To begin with, the review cycle will have a regular timetable, with major announcements made annually in September. And once a new market is announced to be eligible for index inclusion, there will be advance notification of at least six months or potentially longer depending on FTSE Russell’s consultation process. This will allow foreign investors to have sufficient time to prepare for entering a new market – such as opening accounts, on-boarding market makers and FX banks, establishing custody and settlement arrangements.

    Due to the size of China’s bond market, the inclusion process might be staggered, said Ms. Li, which will allow the market to absorb the large inflows that will result from inclusion – minimising volatility and allowing international investors to gradually enter the market over a reasonable phase-in period.

    Hedging and liquidity

    The panel also discussed the issues that international investors have towards China’s onshore bond market. “About five years ago, there a long list of concerns. But that list is a lot shorter and we are now talking about finessing the details,” said Mr. de Silva.

    One issue is the shortage of currency hedging tool available to foreign investors. An active investor cannot hedge onshore, but they can use the offshore NDF market for CNH. This is not an attractive option for a passive investor however, as it creates the possibility of a tracking error. The onshore channels for hedging onshore are quite limited – a bank that does settlement on CIMB Direct can do onshore FX hedging, but that is it.

    “It has been reported that there will be additional initiatives to open hedging up to foreign investors, but that it has yet to happen,” said Mr. de Silva.

    Liquidity is another area that could hinder increased foreign participation into China’s onshore debt market, as a wide range of bonds will need to be actively tradable to meet the demand of both active and passive investors.

    Ms. Li discussed how liquidity may benefit from some structural changes in the market. From an issuer perspective, she said that more reopening and buybacks could be done to increase the average issue size per bond. At the same time the local market for derivatives needs to develop – a well-developed treasury futures and repo market for example, should help to boost bond liquidity. Finally, she said that if market makers are motivated to offer more quotes for off the run bonds, it could help with liquidity as well.

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