At the end of June, China launched the long awaited “Bond Connect” programme with the purpose of linking the Hong Kong and mainland China markets for the first time.
This was a significant effort by Chinese authorities to lure foreign capital into both debt and equity markets, which, despite being the second largest in the world, hold only 2% of foreign capital.
The programme was launched a few weeks after MSCI included 222 domestic shares, or A-share stocks, in its global emerging markets benchmark (index starting next year), a development that satisfied investors and analyst who believed that the potential of local Chinese securities had been oft overlooked by global investors.
And there is certainly reason to feel a degree of optimism about China this year. Economic growth data shows acceleration in for the first time in almost seven years, with GDP rising 6.5% in the first quarter of 2017 from a year before.
This economic expansion has been led by the real estate sector, in turn buoyed by the government policy of making it easy for families to borrow money to purchase homes.
Furthermore, investment, retail sales and industrial output have all reported strong figures. Industrial production rose 7.6% in June from a year earlier, faster than May’s 6.5% while year-on-year growth in retail sales accelerated to 11% in June from 10.7%, according to official data.
However, some analyst believes that regardless of the improved numbers and the government efforts to attract foreign capital into its bond markets, China still has a long way to go before achieving its goal.
Bond Connect Not Enough
The day the program was launched, trading volumes hit over RMB7bn, which reflected a keen interest from investors, though, according to a report by Capital Economics, “there is no guarantee that such levels of interest will be sustained. After all, the HK-Shanghai stock connects also had a strong first day, only for trading activity to subsequently fizzle out,” the report warned.
“There are good reasons to think that foreign demand for Chinese bonds will remain tepid for the foreseeable future. For a start, there is little evidence that market access has been a binding constraint on foreign investment. Most large institutional investors have long had access to the interbank bond market via the QFII scheme. And since that access was expanded to a wider pool of foreign investors early last year, foreign ownership of onshore bonds has only edged up marginally,” the report noted.
Misplaced credit risk remains a major concern for investors as China’s onshore market is dominated by state-owned companies, with high levels of debt and questionable financial health.
According to data presented in the Capital Economics reports, onshore yields have been higher than offshore yields, due to the fact that onshore liquidity conditions are much tighter than those offshore; “3m Shibor is now at 4.5% versus 0.8% for 3m Hibor”. However, traditionally, overseas yields have exceeded onshore yields despite borrowing costs being lower offshore. “This suggests that offshore investors demand a higher risk premium than their onshore counterparts,” the report explained.
For Chang Liu, a China Economist at Capital Economics, the main concerns for investors include: "exchange rate risk, worries about capital controls and mispriced credit risk in China’s onshore bond market. None of these can be easily addressed. Officials have taken some steps to improve market access and allow more corporate defaults in recent years. And more market-based reforms would be positive for the economy in the long-term.”
“But policymakers have shown little appetite for more aggressive action on this front due to concerns about short-term economic stability. As a result, we think progress is likely to remain slow,” Liu added
Even though worries about the Chinese markets continue to emerge, some analyst believes that their capital market is well on its way to becoming the largest in the world, and investors will have little choice but to increases their exposure to Chinese assets as they start to be included in traditional benchmark indexes. However, the actions taken by the Chinese government will be closely watched and will be critical to how the local markets perform going forward.