This Is The Big(ger) News About China’s Capital Markets

Last week index provider MSCI’s inclusion of 222 large-cap A share stocks (traded on Shenzhen and Shanghai exchanges) in its indices removed another brick in the wall between China’s financial markets and the rest of the world.

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But an event of similar or even larger magnitude that has been unfolding in recent months regarding China’s capital market. In March, Chinese Premier Li Keqiang announced plans to create a bond trading link, “bond connect”, that would allow for overseas capital to easily buy mainland China bonds.

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It seems to have gone unnoticed by many financial media outlets. For example, a search on the Wall Street Journal for the phrase “bond connect” will return you only a single article which is only indirectly related.

Since March, more details have emerged, and last month both the Hong Kong and mainland Chinese central banks approved respective Hong Kong and Chinese exchanges to work on rules for the program – which is slated to begin operating before the end of the year.

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Why does this matter?

China’s bond market is the third largest in the world after the U.S. and Japan, at just over US$9.5 trillion. Yet, similar to Chinese equity markets, it remains heavily dominated by local investors. In fact, just 2 percent of China’s bond market is held by foreign investors. By comparison, foreign investors own around a third of the U.S. bond market.

The benefits of opening up the bond market are similar in many respects to the equity market opening. For example, international investors demand more transparency and accountability, with less tolerance to such a heavy hand from China’s regulators who have in the past tended to micromanage domestic capital markets.

Ultimately, the (admittedly long) road to opening up the bond market will lead to a better pricing of risk, and bond yields (i.e. borrowing costs) for companies that better reflect actual market conditions.

But what is happening with MSCI’s equity indices will also eventually happen with global bond indices. Once China’s markets are open enough, mainland bonds will be included in global bond market indices, and this will result in hundreds of billions of dollars of inflows in China’s bond markets.

And bear in mind, the numbers are potentially huge. The global bond market is at least twice the size of global equity markets.

You can already buy China bonds

The pilot scheme will start by connecting China’s interbank bond market in a “Northbound” direction. That means that for now only overseas investors will be able to send their money north from Hong Kong into China’s bond market. The “Southbound” route, that offers mainland investors to trade offshore bond markets will start later. (This is similar to the “stock connect” that opened up the Shanghai and Shenzhen markets to investors, via the Hong Kong stock market.)

But this is not the first time that overseas investors will be allowed to buy Chinese bonds. In 2005 the China Interbank Bond Market (CIBM) scheme was created allowing financial institutions the ability to access the bond market. Over time, more institutions were given permission and bonds were included in quotas for the Qualified Foreign Institutional Investor (QFII) and RMB Qualified Foreign Institutional Investor (RQFII) schemes that provide access to mainland financial securities.

As an individual investor, you can already buy Chinese government bonds though an ETF like the CSOP China 5-Year Treasury Bond ETF (Exchange; HKSE, Ticker; 3199), for example, which uses an RQFII quote for an ETF.

Good investing,

Tama

Article by Tama Churchouse, Stansberry Churchouse

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