China’s journey to global inclusion

    China has come a long way since it first opened its capital markets in 1992 when B-shares were made available to foreign investors. Since then, we have witnessed a series of regulatory reforms including the launching of the qualified foreign institutional investors schemes such as the QFII and RQFII, the China Interbank Bond Market (CIBM), and the Stock Connect and Bond Connect programmes.

    The Chinese journey of liberalisation has continued to accelerate with further evolutions of the currency, stock, bond and derivatives markets. Arguably the two of most significant events in 2017 were the MSCI’s decision to include China A-shares into its emerging market index (effective from June 2018) and the launch of the Bond Connect programme which went live in July 2017.

    China has subsequently emerged as the world’s second-largest stock market by market capitalisation (RMB57 trillion/USD9+ trillion)1 after the US and the third-largest bond market (RMB65 trillion/USD10+ trillion) after the US and Japan2.

    The further opening up of the Chinese capital markets has already brought a host of new opportunities to institutions around the world, and the inclusion of Chinese domestic equities and bonds into global benchmarks could have a profound impact on investment portfolios.

    China bonds to be included in the Bloomberg Barclays Global Aggregate Index

    The CIBM continues to evolve and in order to achieve the inclusion in the global benchmark, the People’s Bank of China (PBoC, the Chinese central bank) has undertaken a series of measures to meet the index requirements including qualifying for investment grade, the local currency renminbi to be freely tradable, convertible, hedgeable, and free of capital controls.

    Recognising China’s efforts on Friday, 23 March 2018, Bloomberg announced that the Bloomberg Barclays Global Aggregate Index will include Chinese yuan-denominated government and policy bank securities beginning April 2019. The move marks another important step for China’s integration with global financial markets.

    The addition of the securities will follow operational enhancements to be implemented by the PBoC and Ministry of Finance, and will be phased-in over a 20-month period with the process expected to be completed in November 2020.

    Local currency Chinese bonds will be the fourth-largest component in the Global Aggregate Index when fully accounted for, after the US dollar, euro and Japanese yen, and would include 386 securities representing 5.49 per cent of a USD53.73 trillion index based on 31 January 2018 data from Bloomberg.

    Additional enhancements are required prior to the planned inclusion date to increase investor confidence and to improve market accessibility. Among these are:

    I. The implementation of delivery-versus-payment settlement: Chinese government bonds purchased through Bond Connect are currently not settled delivery versus payment, which results in counterparty risks for investors

    II. The ability for asset managers to allocate block trades across portfolios: Block trading (buying a bond and splitting it into several funds) is currently not supported under the Bond Connect scheme

    III. Clarification on tax collection policies: Tax clarity is needed for central and local government bonds purchased through Bond Connect. In addition, details on how taxes will be collected for policy bank bonds, which are not tax exempt, are also necessary

    In addition to the Global Aggregate Index, Chinese RMB-denominated debt will be eligible for inclusion in the Bloomberg Global Treasury and EM Local Currency Government Indices starting in April 2019.

    Prepare for the tide of inflows

    Assuming tracking funds of USD2.5 trillion for the Global Aggregate Index, an index weight of 5.49 per cent for China should bring about USD140 billion of foreign inflows into onshore government and policy bank bonds, HSBC Global Research estimates. That would be equivalent to 3.5 per cent of outstanding government and policy bank bonds3. In November 2017, HSBC Global Research also estimated that inclusion in such bond indexes could eventually trigger foreign investor flows of up to USD280 billion into China's bond market4. However, HSBC Global Research views that the inclusion announcement is unlikely to lead to significant inflows immediately for China for two reasons:

    I. The timing of inclusion is not until April 2019. Actively managed funds can, of course, enter the market anytime, but passively managed funds will only invest slightly ahead of April 2019

    II. There are many foreign investors who remain uncomfortable with various aspects of investing in onshore China bonds, be it bond settlement or trading concerns. Operational enhancements therefore need to occur first before these investors will be willing to invest in scale into China

    Compared to other markets of a similar size, China is significantly underinvested by foreign investors as the total foreign ownership is currently less than 2 per cent of the China onshore market5. The index inclusion could potentially bridge the gap and drive up the volume as investment managers readjust their asset allocation to match the index weight. What is more likely is that post-announcement, foreign investors who are currently not participating in the onshore bond market will speed up establishing their accounts and deepen their understanding of onshore trading dynamics. This should lead to a gradual but continuous stream of foreign demand for onshore China bonds.

    Further index inclusions are possible

    Now that Bloomberg has taken the lead by announcing the inclusion of China bonds into its index, investors will likely be closely monitoring if Citi Fixed Income Indices (now part of FTSE Russell following its acquisition) will do the same for its World Government Bond Index (WGBI) and if JP Morgan will also follow suit for its Government Bond Index - Emerging Markets (GBI-EM).

    In March 2017, Citi announced that it will include eligible Chinese onshore bonds into its emerging markets and regional government bond indices, which includes the index WGBI-Extended and three EM and Regional indices: the Emerging Markets Government Bond Index (EMGBI), Asian Government Bond Index (AGBI), and the Asia Pacific Government Bond Index (APGBI)6.

    Impact on global bond markets

    The inclusion of China bonds into the Global Aggregate Index will lead to a gradual reduction in the weights of other markets, particularly those of major markets. For instance, bond markets in the US, the eurozone, Japan, the UK and Canada make up about 87 per cent of the index weight (Table 1). HSBC Global Research estimates that the largest reduction in bond holdings could occur in the US (potentially USD54 billion), the eurozone (USD35 billion), Japan (USD27 billion), the UK (USD8 billion) and Canada (USD4 billion). This should have minimal market impact given the relatively large size of these bond markets as well as investors’ potential preference to stay overweight in these highly liquid markets. Within emerging markets, the flow impact should be minimal given the small index weights allocated to EM countries. If any, the largest potential outflows could be seen in Korea (USD2 billion) and Mexico (USD1 billion).7

    Table 1. Likely impact of China bonds' index inclusion in Bloomberg Barclays Global Aggregate index on other bond markets

    Country Current weight (%) Weights after China's inclusion (%) Change in weights (%) Potential flow impact (USD bn)
    China 0.6 6.1 5.49 138
    US 37.1 34.9 -2.1 -54
    Eurozone 23.3 21.9 -1.4 -35
    Japan 17.6 16.5 -1.1 -27
    UK 5.8 5.4 -0.3 -8
    Canada 3.2 3 -0.2 -4
    Supranational 2.3 2.1 -0.1 -3
    Australia 1.7 1.6 -0.1 -2
    Korea 1.4 1.3 -0.1 -2
    Sweden 0.9 0.9 -0.1 -1
    Switzerland 0.9 0.8 0 -1
    Mexico 0.7 0.7 0 -1
    Denmark 0.4 0.4 0 -1
    Poland 0.4 0.4 0 -1
    Norway 0.4 0.3 0 -1
    Malaysia 0.3 0.3 0 0
    Thailand 0.3 0.3 0 0
    Russia 0.3 0.3 0 0
    Singapore 0.2 0.2 0 0
    Indonesia* 0.2 0.5 0.3 7
    New Zealand 0.2 0.2 0 0
    Others 2 1.9 -0.1 -3

    Note: *Indonesia weights will rise due to addition of Indonesia local government bonds in the index starting June 2018
    Source: Bloomberg, HSBC estimates

    Conclusion

    We believe that China’s successful and recently accelerated integration into the global financial system heralds a new beginning for its broader reform programme, and perhaps more specifically the ongoing liberalisation of its capital markets.

    According to the latest research from academics at the New York University and MIT8, there are two main attractions of Chinese bonds:

    1) they are likely to offer a much higher yield compared with their counterparts in the US and Europe;

    2) they provide a greater diversification benefit due to relatively low correlation with developed markets.

    We believe that this provides options and opportunities for international investment managers.

    At HSBC, we recognise this and work very closely with our institutional clients as they look to access China by providing them with the expertise, the support and the broader professional services that they need to be able to successfully execute on their China strategy.

    Our deep roots and significant on the ground presence in China enables us to connect our clients to what is becoming a key investment market. Despite the recent slowdown, China is still one of the main driving forces for global growth and is expected to grow at 6-7 per cent in GDP over the next few years (HSBC Global Research)9. Such economic growth is stronger than a number of other developed and emerging markets.

    About HSBC in China

    We have a strong track record in supporting our clients, from financing trade to accessing the Chinese markets by leveraging our global footprint and network.

    HSBC has operated in mainland China for over 150 years and has the largest network among foreign banks with 177 outlets in 57 cities 10. We run both an issuer services business – directly supporting much of the origination activity in the Bank, as well as an investor services business focused on the provision of custody and fund administration services.

    HSBC is one of the world’s largest global securities services providers – operating across 37 countries with USD7.7 trillion of assets under custody (as at February 2018)10.

    Our China expertise is supported by our market share. As of February 2018, HSBC's RQFII approved quota is 52.82 per cent and QFII is 35.53 per cent. CIBM is 29.6 per cent in terms of the number of CIBM clients (excluding central banks, international financial institutions and sovereign wealth funds).

    HSBC China has recorded a number of ‘firsts’ in the market:

    1. the only foreign bank to obtain special approval to offer custody services to a sovereign fund’s investment in CIBM in 2005;
    2. the first foreign bank to provide bond settlement agency services in CIBM in 2010;
    3. among the first custodian banks to introduce foreign insurance companies into the CIBM in 2012;
    4. the first custodian bank to assist QFIIs entering into CIBM in 2013;
    5. HSBC facilitated one of the UK’s leading asset managers to complete registration to the PBoC under CIBM direct scheme in 2016, the first direct CIBM deal globally in the market.
    6. We assisted a client with the launch of their Luxembourg domiciled UCITS fund to trade in the CIBM under the Bond Connect scheme, a market first. HSBC Securities Services acted as both the custodian bank and fund administrator of the fund and played a key role from set-up to trading, enabling our client to achieve first-mover advantage.

     

    We have received multiple accolades for our China/RMB services, including the following awards in the recent 2017 Asiamoney Offshore RMB Poll:

    • Best Overall Offshore RMB Products/Services
    • Best for Offshore RMB Fund Services (ie Custodian and Trust Services)
    • Best for Offshore RMB Fund Investment
    • Best for Offshore RMB Clearance, Transaction Banking and Settlement
    • Best for Advice/Information on Offshore RMB Regulations
    • Best for Offshore RMB Research

    1World Federation of Exchanges February 2018

    2China Bond January 2018

    3HSBC Global Research March 2018

    4Asia-Pac Rates, HSBC Global Research, 16 November 2018

    5Bloomberg February 2018

    6Citi March 2017

    7HSBC Global Research March 2018

    8New York University, MIT joint paper March 2018

    9HSBC Global Research forecast 2017

    10Internal HSBC analysis March 2018

    Disclaimer

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