China's Southbound Bond-Connect program may also have an FX task

The China-Hong Kong Southbound Bond-Connect program, which may be launched in the near term, may have FX-related tasks such as helping to recycle the basic-balance surplus and developing the onshore FX-swap market.

This analysis is by Bloomberg Intelligence FX & Rates Strategists Stephen Chiu and Jason Lee. It appeared first on the Bloomberg Terminal.

China has also revamped its bond-holding data disclosure in recent months -- a possible preparation for the Southbound debut.

China could recycle inflows via Southbound Bond Connect

The China-H.K. Southbound Bond Connect may offer another channel for China to recycle its structural basic-balance account inflows, and reduce the current reliance on outflows via the other-investment account -- which may primarily be cross-border loans by the policy banks and the state-owned commercial banks. This may also help reducing the reliance on sovereign funds' cross-border equity investment. Consequently, this could help diversifying these state institutions' foreign assets -- which are also known as the "shadow FX reserves" and are not officially reported as FX reserves.

China may not be willing to revert to regular FX interventions to counter the inflow pressure and suppress yuan appreciation, as this could be be viewed as a back-step in its capital-account and yuan-liberalization push.

China balance of payments (4Q Sum, in $ Million)

 

Trading, settlement almost a mirror image of Northbound

The trading and settlement flows of the Southbound Bond Connect may almost be a reversal of the Northbound program. On trading flow, qualified onshore investors may have to go through China Foreign Exchange Trade System (CFETS) -- which has trading linkage with the offshore market makers via electronic-trading platforms. On settlement flow, onshore investors may establish settlement links with offshore via the Central Moneymarkets Unit (CMU) in Hong Kong, which is already linked to Euroclear and Clearstream. CMU or Euroclear/Clearstream would handle the settlement and custodian holdings depending on the bond type.

The People's Bank of China, China Central Depository and Clearing Co., Ltd (CCDC) and the Shanghai Clearing House (SHCH) could help reporting offshore bond-holding data with the facilitation of the above parties.

Trade, settlement: Tentative flow for Southbound

 

FX conversion and hedging could be done onshore

Apart from investing in yuan-denominated bonds issued offshore (Dim Sum bonds) or using their own sources of FX funding, the FX conversion from onshore yuan to foreign currencies like the dollar and the corresponding FX hedging may be straightforward in the case of Southbound Bond Connect, as onshore investors may be allowed to transact in the CFETS FX market. This development may help lifting the trading volume and growing the onshore FX-swap market. Alternatively, the FX-conversion may be done offshore via the Hong Kong FX-settlement banks, just like the opposite of what is allowed in the case of Northbound Bond Connect.

In fact, the market's focus may be on the Kungfu bonds (dollar-denominated bonds issued by Chinese institutions) initially, with China having greater urgency to recycle the dollar inflows.

FX flows: Northbound vs. Southbound (tentative)

 

CNY/USD FX swap market may extend tenor on Southbound flows

Domestic investor hedging of offshore dollar exposure may allow the domestic USD/CNY FX swap market to deepen. One reason for initiating the Southbound Bond Connect is to create a more balanced FX swap market. FX hedging from foreign investors into the CNY market has been hampered by the lack of liquidity at longer tenors. This might change with the southbound flows, which might provide the off-setting trades of the hedges that the banks need to hedge their positions. As southbound domestic investors hedge their FX risk, especially in the longer tenors of the FX swap market, it should increase the liquidity for foreign investors to consider moving from overnight hedging to one week to three months FX swaps. More importantly, it relieves pressure on the banks running the FX swap risk.

Onshore USD/CNY FX swap volume,CNY 100 million

 

FX hedging activities may rise further

Onshore yuan players may trade more FX derivatives relative to spot going forward, and edge closer to the norm of the dollar FX market eventually, in our view. While the share of spot trading has dropped since April 2016, it remains at a high level compare with the dollar -- representing a still-maturing FX market. That said, China's onshore FX-derivatives turnover could grow toward the dollar's 70% level once outright forwards trading is freed from the 20% FX risk reserve-ratio restriction, and companies are more used to option hedging.

FX turnover: U.S. Dollar vs. Onshore Yuan

 

China identifies holdings related to Bond Connect

CCDC now dedicates one excel (one of the two "N" excel spreadsheets) to cover data pertained to overseas investors. In particular, it offers breakdown of bond holdings and clearing via different investment channels. The first one is the China-Hong Kong Northbound Bond Connect, which started in July 2017, and now accounted for just over a quarter of total bond holdings (see exhibit). The second one is the non-Bond-Connect direct channels, including China Interbank Bond Market (CIBM) Direct, Qualified Foreign Institutional Investor (QFII) and Renminbi QFII (RQFII).

The other "N" excel spreadsheet, which is scheduled to be released later this month separately, will cover data related to China green bonds. This market may grow with China identifying green finance as one area of focus in the 14th five-year plan.

 

Overseas investors' China-bond holdings (March)

 

New ChinaBond website spotlights key data

The new website for CCDC, launched on May 29, may promote official-data transparency and ultimately help domestic and overseas investors to locate market information. The revamped home-page presents four key sections that largely covers all areas that market participants need. The most critical and welcome change, we believe, is now visitors can find "Monthly Bulletin of Statistics" from the new home-page, which were previously buried in the "Monthly Report" column under the "Research" section.

The new version also provides specialized disclosure columns on local-government bonds, enterprise bonds and green bonds that were not previously available nor specifically mentioned in CCDC's new website announcement. Users can now search for information that were not able to search, such as provincial-bond issuance schedule.

Key changes of the ChinaBond website

 

Bond-data reform hints at Southbound debut in 3Q

CCDC, a state-owned financial institution that oversees the depository of about two-thirds of all China outstanding bonds, have stopped releasing the usual monthly bond-data excel-pack (in 24 excel files) from March onwards. Instead, it has published a more streamlined data-pack in the format of eight regular excel files plus "N" excel files (see exhibit). While "N" is set to two for now, we believe the number could rise to incorporate data related to onshore holdings of offshore bonds (facilitated by the Bond Connect Company Limited and Central Moneymarkets Unit in Hong Kong), once the China-Hong Kong Southbound Bond Connect is launched.

Southbound Bond Connect may be debuted as early as in July or August, as Hong Kong Monetary Authority's Chief Executive Eddie Yue said in an interview that this could happen in "early 2H".

Evolution in China bond data on CCDC