China opens the door to global investors

Feeding the demand of global investors to tap the opportunities coming from RMB internationalisation, China has been opening up its onshore capital market over the past few years through a variety of foreign access schemes. One of the latest is the China Interbank Bond Market (CIBM) Direct, which allows a wider range of foreign institutional investors to gain access to the world’s third largest onshore bond market for the first time. On 24 February 2016 the People’s Bank of China (PBoC) issued a directive that relaxed the rules on participation. This opened the door for banks, securities companies, fund management companies, insurance, pensions, and other long-term investors to come into a market that had previously been restricted to the likes of central banks, sovereign wealth funds and few other approved financial institutions.

CIBM Direct created much excitement as the participants in the scheme, known as Qualified Offshore Institutional Investors (QOII¹), would gain access to the wholesale over-the-counter market estimated to be USD 7.3 trillion in size. A few points of ambiguity in the February announcement were cleared up by a second announcement on 27 May made simultaneously by PBoC and the State Administration of Foreign Exchange (SAFE).

The details of the scheme would appear to be very market-friendly and a clear statement from China as to its willingness to provide the appropriate structures for foreign capital.

Why is CIBM Direct in demand?

China’s onshore bond market is now the third largest in the world at around RMB 54 trillion (USD 7.3 trillion). It is not a single bond market however. The Interbank Bond Market, regulated by the PBoC, accounts for about 90% of the total outstanding debts, while the Exchange Bond market under the China Securities Regulatory Commission makes up the remainder.

The expansion of the bond market in China has been significant with 20% annual compounded growth over the last ten years. But it has mainly been a closed market, with only 2% being held by overseas institutions. BNP Paribas expects this to increase to between 5 and 10% over five years. There is likely to be an advantage for first movers, especially when the RMB will be formally included in the Special Drawing Rights (SDR) currency basket of the International Monetary Fund (IMF) in October 2016, hence the wide interest in this untapped new area for gaining China exposure.

It is a dynamic market with huge potential in asset-backed securities, Panda bonds, Green bonds and municipal government bonds all examples of the many emerging opportunities.

Debt Issues

Despite this potential, there is an increased focus on the stability of debt in China and it seems likely that this will be under more scrutiny with this development. The quality of debt seems uncertain, especially given the onshore ratings providing nearly 40% of corporate debt AAA ratings. To date, default rates have been tiny, with only 12 cases since March 2014. But the possibility of this increasing is rising. The defaults that have happened at local or central state-owned enterprises, or SOEs, have particularly surprised investors, and the government’s stated intent to tighten up on industries with over-capacity and overleverage means this is likely to rise. While further defaults may cause a degree of concern, it is only healthy for the market’s long term development to provide a proper premium for credit risks.

Allowing defaults and removing the unofficial guarantee from the government will provide a much more realistic picture of the credit markets in China and will actually prove a positive trend.

If you couple this with the deleveraging underway – initially through limitations on the de facto shadow banking carried out by third party fund managers, restrictions on commercial banks selling classified asset management products and a review of structured wealth products – all these will ultimately lead to more sustainable market operations.

Investor Friendly

The details of the CIBM Direct scheme match the levels of market enthusiasm by providing a flexible and progressive programme. Some of the key elements for international investors looking for direct access to China’s bond market are:

• Eligibility – the scope of investors has increased significantly worldwide to include commercial banks, insurers, security houses, asset managers, charitable funds, pension funds and other long-term investors approved by the PBoC. This extends the list significantly but does leave some questions as to the appetite among investors that may not be long-term in perspective, such as hedge funds, to participate. 
• Ease of application – while financial institutions used to have to seek approval for participation from the PBoC, all that is now required is a filing. The QOIIs can register and open relevant accounts via banks with Type A licences. BNP Paribas (China) Limited is one of the foreign banks that is equipped with such a licence. This is an open invitation to international investors to use CIBM Direct by making it simple to access.

What are the implications?

The CIBM Direct take-up is not expected to go through the roof overnight. There are a lot of positives in the clarifications around the programme. However, the actual reckoning will come from usage and establishment as the norm. This is likely to take a while but should not dampen enthusiasm.

The latest developments will make inclusion of Chinese bonds into international bond indices more likely. This will be a big step in terms of recognition. It is likely to generate a significant impact on inflows from passive strategies alone as inclusions are made by the major index providers. This will position China as the emerging market with the most foreign-owned debt, even if it is still a small percentage of its total.

In terms of trading execution to settlement, foreign investors who are keen to invest into the CIBM Direct will need clarification on the local tax rules and be aware of the T+0 or T+1 settlement cycle. Hence, choosing the right partner as settlement agent or custodian will be crucial for the global teams to operate around the clock and manage streamlined processes across several parties to ensure trade are executed and settled promptly.

In addition, the developments will increase the international scrutiny on the ratings of bonds in China and the possibility of default, as noted above. We would expect to see this start a chain reaction that would ultimately lead to a more realistic and transparent bond market.

Freer access to and from this key market is a big step for capital account liberalisation for China, providing more engagement and opportunities for overseas institutional investors.

Bold Bond Developments

As part of the RMB internationalisation and the opening of China’s capital market, CIBM Direct represents a significant move for the country and it creates a new opportunity for investors around the world to gradually tap into China’s domestic markets. In particular, the clarifications around the programme have confirmed that the Chinese regulators are prepared to continue the progress in opening up their markets and are fully aware of what is required to do this effectively.

The CIBM Direct scheme offers a big step forward in terms of ease, eligibility and unrestricted flows. As participants get comfortable with the new criteria, there will be benefits for the development of the capital market, particularly in liquidity and sophistication of offering. This is a relatively untapped market and there is a wealth of opportunities in China’s domestic market for those investors from around the world that are prepared to adopt quickly. In the long run, we expect to see China expanding other parts of its domestic opening and those who are willing to explore at an early stage will be able to capture the most opportunity.

• Quota – one of the challenges for existing Qualified Foreign Institutional Investors (QFII) and RMB QFII (known as RQFII) has been the restrictions around repatriation and lock-up requirements that have hampered the flow of funds out of China. This is not the case for CIBM Direct as there has been clarification that there will be no limit on repatriation of funds. 
• Funding Currency – the base currency for investment under the CIBM Direct scheme can be either RMB or foreign currencies without approval by SAFE. Previous schemes had been subject to rules on FX handling of investments. The only stipulation in this area is that funds must be repatriated in the same currency as the original payment with a variation of up to 10%, providing for a new flexibility for investment and a control on onshore/offshore currency arbitrage.
• Range of products – the main products available will be cash bonds, bond lending, bond forwards, FRA and IRS. This will enable a certain amount of hedging onshore, mainly of interest rates as FX hedging would still need to happen offshore in the CNH market. There is also the opportunity for RMB Participating Banks to engage in the repo markets for the first time.