By Avery Chen
China launched the long-awaited southbound leg of Bond Connect on 24 September, lowering barriers for mainland institutional investors trading in offshore debts.
The scheme completes the loop for the bond trading link between the mainland and Hong Kong – more than four years after the launch of the northbound equivalent, which has become a major channel for international investors accessing China’s USD18 trillion bond market. Foreign investors held RMB3.78 trillion (USD587.4 billion) of onshore bonds as of the end of August, official data showed.
Southbound Bond Connect is a significant boon for the Hong Kong bond market, promoting renminbi internationalisation. And for mainland investors, it provides a more cost-effective option to add offshore bonds in their portfolios, lawyers said.
“The Southbound Bond Connect opens up to mainland investors opportunities in the Hong Kong market, thus encouraging outbound investment from mainland China,” said Rossana Chu, managing partner of Hong Kong-based LC Lawyers. “It enhances the diversity of investors in the Hong Kong bond market and helps to strengthen the city’s role as a market for raising funds via bonds.”
Liew Chin-chong, a Hong Kong-based capital markets partner at Linklaters, said he expected the new scheme to “drive the internationalisation of renminbi to a new height in Hong Kong” because mainland investors would primarily use renminbi for trade, and they could convert renminbi into foreign currencies.
Before the launch of the Southbound Bond Connect, major access regimes for outbound investment included qualified domestic institutional investor (QDII), renminbi-qualified domestic institutional investor (RQDII) and qualified domestic limited partner (QDLP) schemes.
“Compared to other access regimes like QDII and RQDII, the Southbound Bond Connect offers greater flexibility for asset allocation by allowing onshore investors to trade eligible bonds with offshore market makers directly,” said Minny Siu, a Hong Kong-based partner at King & Wood Mallesons.
The new arrangement is the “southbound mirror image” of the Northbound Bond Connect, Siu explained. “For example, both schemes share a similar trading mechanism and nominee holding structure, and adopt a similar settlement mechanism.
“A key distinguishing feature of the Southbound Bond Connect is that it provides a trading link directly between the China Foreign Exchange Trade System (CFETS) and the offshore market-makers, as an alternative to the trading link via designated offshore trading platforms such as TradeWeb or Bloomberg.”
In the first stage, eligible investors include 41 mainland banks and institutions under the QDII and RQDII schemes. In Hong Kong, 13 financial investors have been designated as market-makers by regulators.
Liew said both Southbound Bond Connect and the RQDII/QDII schemes had specific roles, offering different options for mainland investors.
“There will be mainland Chinese investors who will continue to use the conventional RQDII/QDII channel because they may want to establish a direct and strong presence in the overseas market by trading and settling with institutions in the Hong Kong SAR,” he said.
“The RQDII/QDII channel will also allow the mainland investors to have dealings with dealers and custodian banks outside Hong Kong, and to invest in a broader range of assets such as equity, fund and other products.”
To manage capital outflow from China, regulators have set a RMB500 billion annual quota and a daily quota of RMB20 billion for Southbound Bond Connect. About RMB4 billion worth of bonds were traded through the southbound link on debut, according to the People’s Bank of China (PBOC). However, there was no quota for the northbound leg.
“Capital net outflow under the Southbound Bond Connect is subject to annual and daily quota limits, and operated under a closed-loop model – that is, all sales proceeds of bonds realised under the Southbound Bond Connect must be remitted back to mainland China and exchanged back into renminbi,” said Siu. “The closed-loop system facilitates regulatory supervision of capital flow for timely application of counter-cyclical adjustment where necessary.”
At the initial stage, mainland investors can trade all bonds issued offshore and traded in Hong Kong “with liquidity”, according to the PBOC. But market watchers are waiting for a clear picture of the investment scope.
“The southbound trading seems to cover a broad scope of products, though certain specific eligibility requirements are unclear, for example, what constitutes ‘with liquidity’,” said Chu. “We anticipate further rules or guidelines will be published by the regulators to further elaborate on and refine the scope of eligible products.”
At the moment, only spot trading of bonds is available due to operational or other procedural constraints, according to Liew. “The market would like to see the range of products under Southbound Bond Connect to be extended in the future to include other offshore hedging products such as interest rate swaps, bond lending and repurchase agreements,” he said.
Before investing through the new channel, lawyers suggest that investors be aware of the laws and regulations of both the mainland and Hong Kong.
“Mainland investors would need to familiarise themselves with CFETS trading rules, as well as the settlement/custody rules of Shanghai Clearing House, China Central Depository & Clearing and those of onshore custodian banks,” said Liew. Investors should conduct due diligence on Hong Kong market-makers before working with them.
“Mainland Chinese investors will need to understand that there may be the applicable legal and regulatory requirements in the Hong Kong SAR [as home market] including compliance with the securities law in Hong Kong to the extent the subject bonds are listed in Hong Kong or otherwise convertible into listed shares in Hong Kong,” said Liew.
“Hopefully, the investors are also familiar with potential legal issues in mainland China [as host market],” he said. “For example, if the investors are offering private wealth management products to other onshore (retail) investors on the back of this overseas bond investment, or otherwise granting security to other financiers to raise finance, since all of these will have to be done in compliance with relevant Chinese laws or rules of the settlement system,” said Liew.