This article was written by Andrew Fei.
In recent months, the Chinese government has taken significant steps to further open up its financial markets and financial sector to foreign investment. Notably, foreign institutional investors in the China interbank bond market (CIBM) can now enter into onshore FX risk hedging arrangements with qualifying Chinese financial institutions.
Against the backdrop of exchange rate fluctuations, the ability to hedge FX exposure onshore helps address one of the biggest concerns about investing in China’s rapidly growing domestic bond market. Overtime, these types of reforms will make China’s bond markets even more attractive for international investors and issuers, and pave the way for the inclusion of Chinese bonds in major global bond indices.
Background on the world’s 3rd largest bond market
At RMB 637 trillion, China’s domestic bond market is the third largest in the world and could overtake Japan for the number two spot in the next several years. The CIBM, which is overseen by China’s central bank – the People’s Bank of China (PBOC) – accounts for nearly 90% of the domestic bond market. Yet, at the end of 2016, there were only 430 foreign investors holding approximately RMB 870 billion or 1.37% of all Chinese bonds.
Over the years, the Chinese government has made much progress to open up the domestic bond market to foreign investors and issuers. These efforts help achieve several policy objectives, including establishing China as a leading financial centre, modernising China’s financial system, promoting RMB internationalisation and boosting capital inflows to counteract outflow pressures.
Currently, most foreign institutional investors can invest in the CIBM without being subject to quantitative quotas. These foreign institutional investors include financial institutions and investment products issued by them, pension funds, sovereign wealth funds, central banks, multilateral financial institutions, Qualified Foreign Institutional Investors (QFIIs), RMB Qualified Foreign Institutional Investors (RQFIIs), charitable funds, endowment funds and other mid-to-long-term institutional investors.
China has also actively encouraged foreign entities to issue RMB-denominated bonds (known as panda bonds) and SDR-denominated bonds (known as Mulan bonds) on the CIBM. In this respect, KWM has worked on a number of landmark transactions, including panda bonds issued by South Korea and the Province of British Columbia in Canada as well as the World Bank’s Mulan bond. Currently, the growth of the panda bond market has seen a few technical and other challenges, mainly around remittance of bond proceeds offshore, accounting standards and audit requirements, and the time required for regulatory approval. Working with regulators and industry representatives, KWM is actively involved in addressing these challenges, and expect them to be resolved in due course.
Onshore FX risk hedging arrangements are now permitted
An impediment to further foreign investment in China’s bond markets has been the inability of foreign investors to access onshore FX hedging products. This meant foreign investors had to resort to more expensive offshore FX hedging solutions.
This all changed on 27 February 2017, when China’s State Administration of Foreign Exchange (SAFE) issued a notice (Notice) allowing foreign institutional investors to enter into FX forwards, swaps and options with qualifying onshore financial institutions to manage the FX risks associated with their investments in the CIBM. Qualifying onshore financial institutions are those onshore settlement agents that provide clearing and other transactional services to foreign institutional investors to enable them to invest in the CIBM. Recently, the PBOC authorised several Chinese subsidiaries of foreign banks to act as onshore settlement agents in the CIBM.
SAFE requires the onshore FX hedging arrangement entered into by a foreign institutional investor be reasonably correlated to its actual FX risk exposure to a single or a portfolio of Chinese bonds purchased on the CIBM (Reasonable Correlation Requirement). Furthermore, to give effect to the Reasonable Correlation Requirement, if the foreign institutional investor’s aggregate FX risk exposure changes due to changes to its bond investments on the CIBM, it should make corresponding adjustments to its onshore FX hedging arrangements within 5 working days. It remains to be seen how this requirement would be implemented in practice.
Other than the Reasonable Correlation Requirement, the Notice does not impose specific notional amount or tenor limits and is designed to provide investors with flexibility in selecting suitable hedging arrangements. As China’s onshore derivatives market further develops, the breadth and depth of available hedging products will increase over time.
Other bond market reforms
Chinese regulators are contemplating other reforms to make the CIBM more attractive to foreign investors and issuers. If this trend continues, then we should expect to see the gradual inclusion of Chinese bonds in major global bond indexes, resulting in more capital flowing into China.
In its monetary policy report for the fourth quarter of 2016, the PBOC stated that it will further clarify relevant tax, accounting and auditing policies in order to promote the opening up of the CIBM. According to MA Jun, chief economist of PBOC’s research bureau, the central bank is also exploring the possibility of extending the trading hours of the CIBM.
Further opening up of the financial sector to foreign investment
As previously reported by KWM, China has long been taking steps to attract more foreign investment to its massive financial sector. At the end of 2016, China surpassed the Eurozone to become the world’s largest banking system by assets.
In January 2017, China’s State Council announced that greater access would be granted to foreign investors across a range of sectors in the Chinese economy, including the banking, securities, futures, insurance and investment management industries.
FANG Xinghai, vice chairman of the China Securities Regulatory Commission (CSRC), recently stated that Chinese capital markets – especially the securities and futures markets under the supervision of the CSRC – welcome foreign investors, and that the CSRC plans to gradually raise the percentage limit imposed on foreign ownership of Chinese securities and futures companies. Currently, foreign investors’ stakes in joint-venture securities, fund management and futures companies are generally capped at 49 percent. China’s banking and insurance regulators may be considering similar measures.
Financial stability continues to be of paramount importance
While Chinese regulators have taken significant steps to further open up the country’s financial markets and financial sector, ensuring financial stability will continue to be the paramount consideration.
Senior Chinese officials have consistently underscored the need to seek progress while maintaining stability. This is most recently emphasised in the Chinese government’s 2017 work report, which stressed the importance of constructing a “firewall” around financial risks.
Accordingly, we can expect China to continue to adopt a gradual and incremental approach to introducing and implementing financial reforms.
We will continue to keep you updated on these important developments through our bilingual Chinese financial reform newsletter and more in-depth analysis.