MNI: China's Southbound Bond Connect To Fuel Dim Sum Demand

China is likely to inaugurate the southbound link of its Bond Connect scheme as early as July, allowing mainland investors to easily buy securities in Hong Kong and opening another outlet in the country's capital controls at a time when foreign investment is putting upward pressure on the yuan, policy advisors told MNI.

Four years after the installation of the Bond Connect northbound link which has become an important channel for foreign institutions into the Chinese bond market, the much-anticipated southbound launch will initially boost liquidity in U.S. dollar-denominated bonds as well as yuan-denominated Dim Sum notes traded in Hong Kong, advisors said. While northbound movement is likely to remain much larger, the opening of its southern bound counterpart comes as Chinese authorities accelerate measures to open routes through the still-restricted capital account to allow for yuan outflows, at a time when the currency has come under upward pressure which pushed it to three-year highs in recent weeks.

"It may start with offshore U.S. dollar bonds and Dim Sum bonds at the initial stage before expanding to other regions," said Ming Ming, deputy director of CITIC Securities and a former staffer at the People's Bank of China, adding that quotas granted may resemble those under China's Qualified Domestic Institutional Investor(QDII) scheme. Mainland investors will be attracted by high-yield dollar bonds issued by Chinese corporates as well as by Chinese banks' Additional Tier 1 dollar bonds, and demand could rise if the dollar moves enters an appreciation trend, he said.

PRESSURE VALVE

Bond Connect will offer lower costs and management fees than charged under QDII, said Ming. In the longer run, Connect schemes could link with stock exchanges in London and Singapore, as markets for products including Chinese bond derivatives gradually open to international investors, he said.

Southbound Bond Connect will add a fresh pressure valve for Chinese authorities trying to balance inflows both from foreign investors and also unexpectedly high export receipts.

But risk measures will be key to the link, said E Zhihuan, a member of the academic committee at the International Monetary Institute and chief economist at the Bank of China (Hong Kong). The scheme may encourage purchases in yuan and ensure that funds exchanged for foreign currency are actually used to buy bonds, she said. Investors will also be able to hedge foreign exchange exposure.

"The opening is bound to make cross-border capital more volatile in both directions, but it should not cause too much pressure on capital outflows in the short term," said E. She noted that the total amount of domestic bonds held by foreign institutions was CNY3.68 trillion by end-May, far outweighing the approved quota for QDII investment in the same period totaling USD147.319 billion.

DIM SUM

Much higher interest rates available in yuan than in dollars mean there is currently more incentive for inflows than outflows, said Shen Jianguang, chief economist with JD Tech and a former visiting scholar at the PBOC, adding that much of the money passing through the southbound link will flow into offshore yuan bonds issued by Chinese firms, boosting the Dim Sum market and promoting the use of yuan assets. But mainland investors are likely to have little appetite for foreign government's low-yielding debt, and may baulk at bonds issued by companies about which they know little despite higher returns, Shen said.

In a statement last week, Bond Connect Company Limited said it has been authorised by the China Foreign Exchange Trade System to register mainland investors' choices of Hong Kong settlement banks for currency conversion and FX hedging transactions. The People's Bank of China is finalising details on investment quotas and rules governing what bonds can be bought ahead of an imminent announcement, according to reports.