The recent opening of the China – Hong Kong Bond Connect went relatively unnoticed but it could have long lasting implications for global asset allocations and hedge fund opportunities. Alongside the inclusion of some onshore listed A-shares in the MSCI indices, the Bond Connect can be seen to represent a further step in the opening up of Chinese capital markets – allowing access to the second largest economy on the world, the second largest stock market and the third largest bond market. In spite of the recent focus on capital controls around the onshore currency – arguably largely taken to stabilise the onshore CNY-USD rate – increased access to onshore assets through the stock and bond connect programmes should create more opportunities going forward for both outright and hedged investors.
To recap, the Shanghai-Hong Kong Stock Connect was launched in November 2014, allowing overseas investors easier access to the onshore “A-share” markets in Shanghai as well as allowing onshore Chinese investors access to Hong Kong listed names. Since the launch, the number of eligible names has increased and other limitations, such as an aggregate quota, eliminated. Covered short selling is also allowed. In December 2016, the Shenzhen-Hong Kong Stock Connect was launched, adding the smaller but racier and tech-heavy smaller cap Shenzhen exchange to the mix. These two channels have supplemented the existing QFII (Qualified Foreign Institutional Investor) and RQFII (RMB Qualified Foreign Institutional Investor) schemes. Crucially, this permits settlement in the offshore currency (CNH) which allows investors to exchange and hedge freely, albeit with some basis risk to the onshore CNY.
The Bond Connect allows access in a similar way to nearly $10 trillion of assets in China’s fixed income markets, supplementing previous access through QFII and RQFII as well as the China Interbank Bond Market (CIBM) scheme. This includes all types of bond securities tradable on the CIBM including central and local government bonds, central bank paper, financial policy bank bonds, corporate bonds, commercial paper, asset-backed securities and so on, as well as subscriptions for new issues. The People’s Bank of China (PBOC) has said that hedging tools such as bond repos (repurchase agreements) and interest rate derivatives will be available in the future. To an investor, Bond Connect means avoiding lengthy and complicated registration procedures, fewer restrictions such as a lock up on investment principal which was part of the earlier schemes, and more clarity on repatriation of sale proceeds.
In equity markets at the moment, offshore investors have typically invested in Hong Kong listed names (“H shares”) as well as those Chinese entities listed on the US exchanges. Access to onshore markets gives an investor the ability to trade a much wider breadth of industries and over 1500 more stocks of over $6.5 trillion market capitalization (some are dual listed in Hong Kong, but not fungible, leading to relative value opportunities). The offshore markets (Hong Kong has just over 1000 stocks worth just over $2.3 trillion while there are about 90 listed ADRs worth nearly $1.5 trillion) are dominated by the big tech names and state owned financials. Many of the consumer and healthcare names that are potential beneficiaries of the move towards a consumer-driven economy are onshore names.
Daily Turnover – Shanghai–Hong Kong Stock Connect and Shenzhen–Hong Kong Stock Connect
Source: Bloomberg. From Nov 17 2014 to July 10 2017.
Correlations Between Global Market and Chinese Markets
Source: Bloomberg. From Nov 2014 to June 2017.
CSI300 is an index of 300 large stocks drawn from Shanghai and Shenzhen.
SHCOMP is an index of all stocks that are traded at the Shanghai Stock Exchange.
HSCEI is the major index that tracks the performance of China enterprises listed in Hong Kong in the form of H shares.
CHINEXT is a Nasdaq-style board dominated by smaller tech companies.
Performance of State and Private Companies in the Onshore Markets
Source: Bloomberg. From Nov 2014 to June 2017.
To be fair, the volumes crossing the stock connect have probably not been as robust as was hoped for at the launch, as relatively higher onshore valuations and the popularity of many of the (offshore) tech names have kept offshore investors away from onshore listed names (Figure 1).
The recent inclusion of 222 A-shares into the MSCI indices (all standard country and regional indexes, including MSCI China, MSCI AC Asia, MSCI Asia Pacific ex-Japan, MSCI EM, and MSCI All Country World), after much consultation, can be seen as a further step in the internationalisation of the Chinese domestic capital markets. Yet, so far, only 5% of the Shanghai index market capitalisation of ~$700bn is being included bringing onshore Chinese exposure to just 0.1% of the MSCI World. While the impact of this inclusion is expected to be minimal, it is likely that over time its effect will be much greater. Interestingly, with low foreign participation and high retail interest, Chinese domestic markets have historically been quite uncorrelated with global markets (Figure 2) as well as giving differing returns both intra- and inter-sector, and between private- and state-owned enterprises (Figure 3).
In fixed income, the market has been developing quickly onshore – partly as a response to the massive growth in leverage, particularly at the corporate and local government level. While issuance continues to grow, secondary trading and credit discovery are weak. At the same time as the Bond Connect launch, the PBOC announced that qualified international credit agencies will be allowed to operate in the CIBM. This should help improve pricing and align ratings with the almost $1 trillion offshore pan-Asian (including Japan) bond market – at the present time onshore paper can trade at vastly different ratings and spreads from paper issued offshore by the same company (admittedly with differing legal structures and protections). After hedging back to USD, onshore yields are at the moment not particularly attractive. Foreign participation represents just 1.2% of the overall onshore market and 4% of the China Government Bond (CGB) market – much lower than more developed peers. Assuming the global bond index providers follow MSCI’s lead, and particularly at the sovereign level, where the IMF’s Special Drawing Rights (SDR) status should lead to increased ownership, the flow of funds could be enormous. Some commentators are expecting $250-300bn in flows over the next 36 months.
We are not arguing that all is rosy in China – challenges abound at both the macro and the corporate level. Government-driven intervention if problems arise is a fact of life: witness the propping up of the stock market in mid-2015 and the recent short squeezes in offshore CNH funding designed to protect the currency. A cynic might suggest with some credibility that increased access to the onshore markets helps support the fixed income markets and thus the leverage in the economy with overseas capital. Corporate governance and transparency, particularly at the local government level, can differ widely. What the increase in access does provide though, is the opportunity for investors to perhaps better understand and take advantage of the changes in the world’s second largest economy.
David Walter is a Director at PAAMCO and serves as Head of Research for Asia. He sits on AIMA Singapore’s executive committee.
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 Source for market capitalization: Bloomberg; Source for industry and equity list: https://www.hkex.com.hk/eng/market/sec_tradinfra/chinaconnect/Eligiblestock.htm
 Source for ADR count and AUM: Bloomberg; Source for Hong Kong equity list and market capitalization: https://www.hkex.com.hk/eng/stat/statrpt/mkthl/mkthl201706.htm
 Morgan Stanley – “Implications of Mainland-Hong Kong Bond Connect” July 3, 2017