How China Is Cracking a Window for Its Bond Investors

(Bloomberg) -- China is taking another step to loosen its capital controls and in the process is giving onshore investors greater access to a previously hard-to-reach bond market. The so-called southbound link of the Bond Connect program will help draw capital from the mainland to bonds available in Hong Kong, which are currently a challenge to buy due to regulatory restrictions. The new channel could serve to check excess strength in China’s currency by balancing money flowing from overseas funds into Chinese assets. It also could help buttress Hong Kong’s status as a financial hub.

1. What is this link exactly?

Southbound Connect, which opened Sept. 24, offers a way for mainland investors to buy bonds normally targeted at traders outside China. It completes the loop four years after a northbound link gave foreign funds access to China’s interbank bond market via Hong Kong. The People’s Bank of China has set the annual quota for the southbound program at 500 billion yuan ($77.7 billion) and a daily quota of 20 billion yuan, with both to be adjusted based on cross-border fund flows.

2. What’s the rationale?

It’s part of China’s push to modernize its financial markets and allow for more cross-border fund flows. (The government has long kept a tight grip on money flowing in and out so as to preserve the value of the yuan.) The northbound link has allowed overseas investors to build up holdings in the onshore debt market to a record 11% from 4% before it was launched. The southbound channel could help bring some equilibrium. It also allows domestic traders to diversify their portfolios, give Chinese banks someplace new to park surplus holdings of U.S. dollars and deepen the domestic foreign-exchange swap market.

3. What is the greater purpose here?

First, to help take some heat off the yuan when it’s rising too rapidly. While authorities want to avoid a huge exodus of funds out of China, they’re eager to increase outflows somewhat to help prevent the currency from rising too fast, especially if a rally isn’t in step with growth in the economy. The southbound link should help achieve that as domestic traders will need to sell yuan to buy Hong Kong dollars or other currencies to purchase assets through the channel. This reduces the need for the PBOC to intervene directly and furthers its goal of allowing the currency to be more influenced by market demand. For Hong Kong, the southbound channel helps bolster the city’s role as the bridge to the lucrative mainland market.

4. How will this work?

Similar to the northbound link, the southbound is run by Bond Connect Company Ltd., a joint venture between the Hong Kong exchange and China Foreign Exchange Trading System, an arm of the PBOC. Trades are conducted through the Central Moneymarkets Unit run by the Hong Kong Monetary Authority. Bloomberg LP, the parent company of Bloomberg News, provides Bond Connect services. Hong Kong-issued yuan bonds -- also known as Dim Sum bonds -- as well as U.S. dollar- and Hong Kong dollar-denominated notes will be available. Some 41 banks and certain qualified investors can participate during the initial phase. 

5. Is there a stocks version of this?

Yes, and it’s been a huge success. The southbound stock link between Shanghai and Hong Kong was launched in November 2014 and another channel was set up between Shenzhen and Hong Kong two years later. Together, they have become one of the biggest sources of money flows for the Hong Kong market. In January, mainland traders purchased record amounts of Hong Kong-listed equities -- pushing the benchmark Hang Seng Index to the highest level since May 2019 -- even as international investors were forced to dump some securities after a U.S. ban. An average HK$3.7 billion ($475 million) has traded daily through the southbound stock connect in the past year.

6. How else can Chinese investors access offshore markets?

There are a few other channels that currently allow onshore investors to buy securities overseas. These include the Qualified Domestic Institutional Investor (QDII), RMB Qualified Domestic Institutional Investor (RQDII) and the Qualified Domestic Limited Partnership (QDLP). But investors have limited options through these programs as they cannot independently choose bond types and when to buy or sell, according to a state media report. The southbound link is likely to allow more autonomy in trading (investors in the first two categories are eligible to use it). Another channel known as Wealth Management Connect is also set to launch as soon as October. That program will allow eligible residents in nine southern Chinese cities such as Shenzhen to invest across the border in Hong Kong and vice versa.

The Reference Shelf:

• Bloomberg Intelligence examines the potential impact of the southbound bond link and reviews options on how it might be set up.
• The official website of the Bond Connect program by Hong Kong Exchange and China Foreign Exchange Trade System.
• Comments from officials in Hong Kong and from the Hong Kong Monetary Authority about the southbound bond channel.
• QuickTakes on China’s market opening, its digital yuan ambitions and the tools it uses to manage the yuan.

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