China's new connects are long game, not FX game changer

This article was written by Bloomberg's Chief Asia Economist Chang Shu. It first appeared on the Bloomberg Terminal.

The launch of the Wealth Management Connect Pilot Scheme on Friday and plans to start southbound trading in the Bond Connect mark more progress on China’s financial opening.

The programs look set to be modest in scope and scale in their trial stages, but should become useful cross-border flow channels over time -- and go some way to addressing long-standing imbalances between capital inflows and outflows.

The moves will increase China’s financial links with the rest of the world, which are still tiny relative to its economic weight.
For the exchange rate, any impact is likely to be limited from the get-go and over the longer term.

China's financial flows

Source: Bloomberg Intelligence

The large gap between inbound and outbound capital flows is a product of China’s past emphasis on opening inbound channels before outbound routes.
The two-way Wealth Management Connect and the southbound Bond Connect are among a number of recent steps aimed at restoring more balance.
The willingness to allow more cross-border flows suggests the authorities are less worried these days about sudden surges in outflows that could drive down the yuan.

Wealth Management Connect and Southbound Bond
The Wealth Management Connect Pilot Scheme launched on Friday allows investment in Chinese financial products by residents from Hong Kong and Macau in the onshore market, and by residents in the Greater Bay Area in the offshore segment.

There’s a cap of 150 billion yuan ($23 billion) in each direction, and a limit of 1 million yuan for individual investors. The products are limited to non-complex, medium-risk instruments.

Southbound trading in the Bond Connect will enable domestic market players to invest in bonds in overseas markets. The opening of this channel comes four years to the month after China began northbound trading in the Bond Connect. It follows a series of Stock Connect programs, which China introduced in 2014 and gradually widened in scope.

Programs to help correct inflow-outflow imbalance
China has been accelerating the pace of financial opening. Among the recent big moves, it allowed full foreign ownership of Chinese financial companies ahead of schedule in 2019, and removed a quota for the Qualified Foreign Institutional Investor scheme in May 2020.

China’s limited financial linkages with the rest of the world -- which are particularly meager relative to the size of its economy and its importance in trade -- point to the importance of continued financial opening.

Even with rapid growth over the past decade, China’s portfolio flows with the rest of the world -- inbound and outbound combined -- amounted to $1.8 trillion at end-2019, just 2.4% of the world total.
This is equal to 13% of China’s GDP, far lower than comparable ratios for the U.S. (125%), Japan (142%) and South Korea (74%).

The simultaneous launch of the Wealth Connect in two directions breaks a pattern in China’s financial opening -- opening of outflow channels has tended to follow inflow channels:

Inbound and outbound flow ratio

Source: International Monetary Fund, Bloomberg Economics

Foreign direct investment was initially opened up in the late 1970s as part of China’s economic opening and as a way of promoting exports. It was was further boosted in 1992 as part of an acceleration in structural reforms, and again in 2001 when China joined the World Trade Organization.
China’s overseas direct investment has accelerated in the last decade, after it formalized a ‘go-out’ strategy in the early 2000s.
The introduction of the QFII scheme in 2002 marked the beginning of portfolio inflows. Its mirror for outflows -- the Qualified Domestic Institutional Investor scheme -- was introduced later, in 2006.

In 2014, China started a series of Stock Connect programs, which enabled offshore participants to invest in onshore equities, and onshore players to invest in offshore equities. The fund flows are subject to a daily quota, with higher quotas for northbound flows than southbound flows.
The Bond Connect program, launched in 2017, was another example of prioritizing inflows.

As a result, financial flows are highly unbalanced. The stock of outward portfolio investment stood at $567 billion as of 2019, less than half the inward flows.

Market incentives key for long-term connect flows

The northbound leg of the Bond Connect has been a success. Flows through this channel reached 4.8 trillion yuan in 2020, dwarfing 209 billion yuan in northbound Stock Connect flows. Relatively high yields on yuan-denominated bonds help drive the bond inflows.

Connect program flows

Source: Hong Kong Stock Exchange

The Stock Connect has seen more southbound flows, reflecting the incentive of diversification on the part of mainland investors and cheaper valuation of stocks traded in Hong Kong.

This suggests the attractiveness of the connect programs will hinge partly on market incentives.

Southbound bond trading, for example, will offer a means for onshore players to diversify portfolios and a place to park excess dollar liquidity. But relatively low yields on dollar-denominated bonds reduce the incentive to move investments offshore.
The Wealth Management Connect could offer strong incentives in both ways -- diversification for mainland investors on the one hand and access to the onshore market by the overseas investors on the other.

Exchange rate not the aim

We don’t see this new flow channel moving the needle for the yuan’s exchange rate, now or going forward:

The modest size of the initial fund flows will limit any impact.
The launch of the southbound Bond Connect sends a signal that fears of a repeat of the sort of fund outflows that drove a yuan devaluation in 2015 have largely faded.
Experience from the stock connect programs suggests limited FX impact over time -- net outflows on those channels haven’t affected the exchange rate in a consistent way over a longer horizon.

Exchange rate and Stock Connect flows

Source: Hong Kong Stock Exchange, Bloomberg