The 3rd of July 2017 marked the launch of Bond Connect, which in years to come will probably be remembered as a watershed moment along the path of internationalisation of the renminbi. If looked at narrowly, the significance of Bond Connect can sometimes be overlooked, so as we approach the first anniversary of it’s launch, we revisit the scheme and the implications for financial markets in China, and the longer term impact on the global financial system.
Firstly, what exactly is Bond Connect? The program allows international investors to access the domestic bond market which is often referred to as “Northbound” trading. The program is in fact two way, although currently “Southbound” trading, facilitating flows in the other direction, has yet to be sanctioned. Bond Connect is a much simpler mechanism for foreigners who previously had to use other schemes, such as RQFII, which required a pre-approved quota, with a much longer and more involved process than Bond Connect.
China is home to the third largest bond market in the world, issued by one of the relatively few creditor nations in the world, with 10 year yields currently trading at 3.55%. Much to the surprise of many, the renminbi has been one of the world’s strongest currencies over the past decade, aided by the country’s large current account surplus, which in absolute terms is the 3rd largest in the world, ranking behind only Germany and Japan.
Academic research supports the idea that countries that run cumulative current account surpluses over extended periods, tend to see their currencies appreciate (and vice versa) and our analysis suggests the currency could appreciate by 4% per annum against the dollar, when interest rate differentials are taken into account. When compounded over many years, that equates to a significant return for investors who might otherwise have held currencies such as the US dollar and sterling. The US and the UK have the largest current account deficits in the world and this marks them out likely to be poor stores of value. Given that foreigners hold under 2% of the Chinese bond market, that figure can only increase over time and one of Bond Connect’s key benefits is that it helps to facilitate those inflows.
And that could be the end of the story. Except that isn’t the key story at all. What most people seem to have overlooked is the fact that increased inflows by international investors then opens up the possibility of Chinese capital outflows, WITHOUT exerting downward pressure on the exchange rate. This notion conflicts with most people’s assumption that greater outflows from China equates to a weaker renminbi.
To make sense of this we need to look more closely at the channels for outbound capital, the most significant of these being QDII and RQDII. The former gets most of the press attention as that channel allows Chinese capital to flow abroad into (so-called) hard currencies like US dollars or sterling, for example. The QDII channel was reopened in April 2018 although the additional quota was only increased by USD 9 billion, a tiny sum in the context of global financial markets.
Less widely reported is RQDII, which channels renminbi from the domestic markets into international markets, the main requirement being that these assets must either be denominated in, or hedged back into renminbi. Why is this so important? Well, until recently, Chinese institutions were heavily restricted in their ability to access international markets and hence they have poorly diversified portfolios consisting of Chinese cash, Chinese bonds, Chinese equities and Chinese property. Going forward, that mix will change, and the sums are mind boggling.
Estimates vary, but it widely accepted that the sums are measured in the trillions of US dollars. That will have significant implications for the entire global financial system over the next several decades. Which is why we believe that Bond Connect will, in years to come, be credited as one of the key mechanisms, not just for allowing inflows into China, but also for its role in helping to facilitate outbound capital as well.