In Brief:

• China’s fixed income market is opening further and investors are likely to increase their allocations to Chinese bonds beyond the 2% of the market they currently own¹.
• This increase may happen actively, as trading vehicles like the Bond Connect make trading in and out of Chinese bonds easy and efficient for international investors, or passively, as Chinese government bonds are included in global bond benchmarks. China’s weight in the widely tracked Bloomberg Barclays Global Aggregate Bond Index will rise to around 6% by the end of 2020. This inclusion, and others like it, could attract billions in inflows.
• The increasing transparency of Chinese bonds’ ratings will add confidence to international investor decisions regarding the onshore market. Still, information gaps could remain as international ratings agencies adapt to the Chinese bond market and investors remain concerned about the accounting standards of some local industries.
• The internationalization of the Chinese renminbi (RMB) has been instrumental in helping Chinese bonds go global. Disparities between onshore and offshore RMB settlement and the low usage of the RMB outside China still present challenges to China’s goal of establishing a major global fixed income market.
• All of these dynamics are constantly evolving. Investors need to closely monitor the Chinese market to take stock of recent developments as the market continues to internationalize. 

Going global

Though often moving in fits and starts, China has been opening up its capital markets to inbound foreign investment since the early 1990s. Outbound investment remains more controlled, but is also liberalizing. These changes are especially notable in financial assets such as bonds and equities.

Throughout this century, various schemes allowing foreign investors, usually institutional ones, to purchase Chinese assets have been piloted. Achieving China’s goal of hosting one of the world’s major financial markets necessitates even further liberalization. For the average foreign investor, the most significant of these ongoing changes was the establishment of the Stock and Bond Connect trading platforms. Despite these policy changes, and the inclusion of Chinese financial assets into major global benchmarks, international investors’ allocation to Chinese assets run below what China’s market size merits, for a variety of reasons. Here, we explore the variety of vehicles through which investors could access Chinese assets and the impact of China’s further opening up on investors’ holdings. 

Global investors hold a much lower share of the Chinese bond market than they do in many other emerging markets, and certainly much lower than their share of developed markets’ bonds. For example, foreign investors own around 7% of Korea’s combined government and corporate bond market, while foreigners only hold around 2% of China’s debt securities³. This share will undoubtedly rise over time as international investors become more familiar with the Chinese bond market and accessibility improves. But the process will be gradual, given liquidity challenges (discussed in Paper #3: Characteristics of Chinese bonds). Global benchmark inclusion will also help. Chinese bonds’ entry could prompt passive inflows of between USD 250billion and USD 300billion, further diversifying the investor base². 

China is opening up its bond market 

The launch of Bond Connect—a trading vehicle through which investors can freely purchase and trade onshore bonds for accounts in Hong Kong without being subject to individual quotas—represented a major step in making onshore bonds accessible. Bond Connect is the latest of several programs to allow inbound foreign investment in debt securities (Exhibit 1). 

Here, we provide a summary of current and previous access programs for the Chinese fixed income market:

• Qualified Foreign Institutional Investor (QFII): In 2002, China launched the QFII program. This program allowed international institutions to invest in listed stocks (such as A-shares), sovereign bonds, corporate debt and other financial instruments approved by the China Securities Regulatory Commission (CSRC). Although the launch of QFII was a step toward opening up the market, the program itself was quite restrictive. Indeed, qualified investors saw their ability to trade Chinese assets constrained by a quota set by the State Administration of Foreign Exchange (SAFE). In 2018, this program was liberalized further when the ability of foreign investors to repatriate their assets was improved. And even further liberalization occurred in 2019, when quotas were abolished.


• RMB Qualified Foreign Institutional Investor (RQFII): In 2011, CSRC together with the People’s Bank of China (PBoC) and SAFE, launched the RQFII program to further facilitate foreign investment in domestic markets. RQFII is more flexible than QFII in some key ways. For example, it relaxes restrictions on currency settlements, fund repatriations and investor qualifying criteria. It also broadened the pool of eligible assets. Chinese regulators also dropped RQFII quotas in 2019.


• QFII/RQFII: In 2019, CSRC proposed merging both programs to facilitate foreign investment into Chinese domestic markets and unify the regulations concerning foreign institutional investors. This would go a long way toward removing a regulatory hurdle for institutions as they would now be able to operate under a single regulatory framework.


• China Interbank Bond Market (CIBM) Direct: CIBM Direct was launched in 2016 and, in some respects, is an enhancement of the QFII/RQFII schemes. Under CIBM Direct, investors no longer need to receive approval before trading if they have pre-filed their registration with the PBoC. Investors in this market are not subject to quotas or lock-up periods like in the QFII/RQFII programs. Cash bonds and interest rate derivatives are available to foreign investors under this program, whereas these tools were unavailable through other programs. Still, CIBM Direct does limit foreign capital from flowing into non-interbank bond assets.

• Bond Connect: This is the newest initiative to open the onshore bond market to foreign investors. Launched in 2017, Bond Connect allows foreign investors to trade in the CIBM from Hong Kong accounts and exempts them from quotas. Investors no longer need to open an onshore account, nor seek PBoC or SAFE approval to invest in China’s domestic bond market. The ease of using this access channel has contributed to its popularity among investors, with the number of users rapidly outpacing those using QFII/RQFII. As of October 2019, there were 1,377 registered users of Bond Connect⁴.

There are three main programs through which foreign investors can access the Chinese onshore bond market
EXHIBIT 1: PROGRAMS FOR INBOUND BOND INVESTMENT IN CHINA

Source: HKEX, PBoC, J.P. Morgan Asset Management. Data are as of October 31, 2019.

Even though Bond Connect was launched relatively recently, it has proven popular. Currently, more than 1,000 investors are using this program, exceeding the total number of investors under previous schemes⁵. Obviously, these schemes only apply to onshore bonds. Investors can access the offshore RMB-denominated bond market through Hong Kong, and the foreign currency-denominated bonds of Chinese companies through a number of Asian bond trading venues. 

China and international rating agencies: 2019 marks a new milestone

The rising number of ratings agencies that can evaluate onshore debt is contributing to global investor comfort with the Chinese bond market. International agencies have long monitored foreign currency- and offshore-issued debt from Chinese companies. However, the onshore landscape is more complex.

Standard & Poor’s started monitoring Chinese government bonds (which are listed onshore) in 2004, Fitch Ratings began earlier in 2001 and Moody’s Investors Service began in 2010. Consideration of local currency corporate debt is a more recent development. International rating agencies were barred from the Chinese market until 2019. Instead, investors have relied on domestic monitoring agencies for assessments of locally issued debt. 

The differences in the processes of foreign and domestic agencies, and the different rating scale utilized by onshore agencies, were sources of confusion for early international investors (discussed in Paper #3: Characteristics of Chinese bonds). This year, S&P Global became the first international agency allowed to rate financial and non-financial issues onshore, as well as rating structured finance bonds and RMB-denominated bonds from foreign issuers (Panda bonds) listed on onshore exchanges. Other agencies may soon follow.

The added confidence in investment decisions within the Chinese bond market that the big ratings agencies can offer international investors comes more from their familiar framework than from the actual rating they assign to individual issues, in our view. These agencies will utilize ratings systems investors have become accustomed to and weight the variables in their evaluations of bonds in the same manner they do elsewhere. Such a service will enable investors to more directly compare their other holdings to bonds for sale in the Chinese markets. Investors will need to keep in mind that such agencies will still be operating within the domestic market and subject to the same regulatory landscape of the Chinese companies they rate, which will necessarily require some adjustment to their evaluations to take into account local dynamics. However, in our view, the biggest benefit of the major international agencies having a presence in the local market is the additional confidence they can offer international investors in interpreting locally issued ratings and in appropriately pricing the known risks.  

Access for international rating agencies is an important milestone for the internationalization of the Chinese bond market. Ratings that comply with international standards help reinforce foreign investor confidence in assessing onshore bonds. This move also confirms Chinese authorities are willing to take steps to attract foreign investors.

While international investors may prefer referencing the ratings from one, or all, of the international agencies, domestic agencies also rate domestic bonds, as mentioned earlier. Despite other distortions present in the onshore bond market, such as tradability and the presence of implicit guarantees (discussed in Paper #3 Characteristics of Chinese bonds), bonds are responsive to ratings⁶.

Internationalization of the RMB

While these operational developments have generated greater interest among foreign investors, the reforms would be moot if investors could not translate any returns back into their home currency cheaply and efficiently.

Currently, the RMB is not freely convertible. RMB convertibility from offshore RMB (CNH) to onshore RMB (CNY), and from RMB into other currencies, is a managed process subject to foreign exchange control policies of, and restrictions imposed by, the Chinese government. This has been identified as an area for future reforms. A decade ago, investors could only trade CNY for CNH indirectly through derivatives like non-deliverable forwards. Currently, investors are now able to trade directly between CNH/CNY. 

The convergence between the exchange rate of the CNH and the CNY has also been a necessary step in the RMB’s internationalization. Formerly, while market forces held sway of the CNH market, government intervention—and at times a strict peg—held the CNY exchange rate stable at a level acceptable to Chinese authorities. Predictably, this led to wide deviations between the CNH and CNY.

China’s policymakers have been gradually introducing more market forces into the onshore market. While the CNY still isn’t a fully free-floating currency, and government-linked institutions have been active in the CNH market, reforms have led to a more equal exchange rate and the taming of deviations in volatility between these two markets. 

China widened the CNY’s authorized trading band in 2012, and again in 2014, hence handing over part of its currency management to the markets (Exhibit 2). A 2% daily range of movement certainly is not freely tradable, but greater investor influence has driven the level of RMB volatility closer to that of other currencies. High exchange rate volatility is unwelcome for those seeking to translate returns to a home currency, but the growing influence of market forces on asset prices, including the RMB, add to investor confidence that they can utilize investment strategies they have used elsewhere.

The RMB has grown more volatile, but still trades within a narrow range
EXHIBIT 2: EVOLUTION OF RMB EXCHANGE RATE AND ALLOWABLE TRADING BANDS
CNY/USD

Source: Refinitiv Datastream, J.P. Morgan Asset Management. PBoC is the People’s Bank of China, which oversees exchange rate policy. Data are as of October 31, 2019.

As settlement in RMB became an easier process, China started to encourage the global use of the RMB. For China’s fixed income market to become globally significant, as the government envisages, it is essential to have the RMB become widely traded and a reliable currency for asset pricing. In November 2015, the International Monetary Fund (IMF) gave China’s efforts a major boost when it added the RMB to its Special Drawing Rights (SDR) basket.

The SDR basket is an artificial currency made up of a variety of individual currencies the IMF has determined are liquid enough and offer a deep enough market for them to be reliably called upon to help central banks manage their operations. The RMB’s inclusion is a technical point, but its entrance meant the RMB would also join the currency benchmarks of global reserve managers. In the SDR basket the RMB has a weight of 11%, behind the USD (42%) and the euro (31%), but ahead of the yen (8%) and pound (8%) (Exhibit 3). Practically, this means global institutions will increasingly allocate some of their reserve to the RMB, and thus have to hold RMB-denominated assets, furthering the internationalization of Chinese markets and supporting the RMB value. 

Even though SDR inclusion was a victory for China, usage has been muted so far. The share transactions conducted in RMB dropped from 2.3% in 2015 to 2.0% in October 2019, as measured by SWIFT. Reserve managers have also been hesitant to allocate more of their FX holdings to RMB. Currently, only about 1.9% of global FX reserves are in RMB (Exhibit 4).

SDR inclusion was a victory for China
EXHIBIT 3: CURRENCY WEIGHTS IN SPECIAL DRAWING RIGHTS BASKET
% of total

Source: IMF, J.P. Morgan Asset Management. Data are as of October 31, 2019.

The slow adoption could be due to lingering reservations investors have about its tradability, the volatility of RMB-denominated assets and general concerns about the state of China’s economy. The difficulty of accessing onshore Chinese assets has not helped. International managers will likely gradually increase their usage of the RMB as reforms, such as the Stock and Bond Connect programs, improve ease of access to RMB-denominated assets. 

Reserve managers have been slow to adopt the RMB
EXHIBIT 4: GLOBAL RESERVE MANAGER HOLDINGS
% of total

Source: Currency Composition of Official Foreign Exchange Reserves (COFER), International Financial Statistics (IFS). Data as of June 30, 2019.

China’s inclusion in global bond benchmarks

Encouraged by the measures Chinese regulators have taken to increase foreign investor access to its domestic markets, to stabilize and internationalize the RMB and to allow international rating agencies to rate Chinese issuers, many global investment benchmark producers are considering including, or have decided to include, Chinese onshore assets in their indices. 

As with other waves of financial liberalization in China, the equity market went first. In 2018, MSCI started to include China A-shares into its emerging market (EM) indices. This gradual MSCI inclusion continues in 2019 and other providers could follow. By the end of the year, the weight of China A-shares within the MSCI EM Index could reach 3.3% (up from 0.8% in May 2018), and after their full inclusion A-shares could reach 16.2% of the index. This inclusion could generate up to USD 150billion of additional inflows into A-shares⁶.

Following equities, bond markets are next up for benchmark consideration. The Bloomberg Barclays Global Aggregate Bond Index began to add Chinese onshore government and policy bank bonds in April 2019, and plans to gradually increase their weight over a period of 20 months until their share of the index reaches roughly 6%. The frequently referenced J.P. Morgan Government Bond Index—Emerging Markets (GBI—EM) plans to begin incorporating onshore Chinese central government bonds, up to a weight of 10%, starting in February 2020. Other major bond indices, such as the FTSE World Government Bond Index, are also considering adding Chinese onshore bonds. These three benchmarks, even at their planned low inclusion weights, could draw potential additional inflows of between USD 250billion and USD 300billion into China’s onshore bond market (Exhibit 5) ⁷.

These benchmark inclusions have been supportive for equity and bond prices. Additionally, the inflows into the onshore market could support the RMB over the next couple of years.

Benchmark inclusion could boost RMB portfolio flows
EXHIBIT 5: ESTIMATED ADDITIONAL INFLOWS AS A RESULT OF BENCHMARK INCLUSION
USD billions, BENCHMARK Index

Source: IMF Global Financial Stability Report April 2019, JPMorgan Chase & Co; Arslnalp and Tsuda (2014); and IMF staff estimates, J.P. Morgan Asset Management. JPM GBI-EM = JPMorgan Government Bond Index-Emerging Markets; Bloomberg Global Agg = Bloomberg Barclays Global Aggregate; FTSE = Financial Times Stock Exchange Group; WGBI = World Government Bond Index; MSCI AC World = MSCI All Country World Index; EM = emerging market; RMB = renminbi. Data are as of October 31, 2019.

Investor ownership likely to rise

Chinese bonds are in the process of going global. Investor access to the onshore market has improved significantly through the establishment of programs such as Bond Connect. Additionally, the ongoing internationalization of the RMB, both as a reserve currency and as the Chinese exchange market itself becomes more responsive to market forces, makes onshore Chinese assets more investable than ever before.

Still, high volatility in the exchange rate and the gradual process of standardizing ratings for Chinese bond issuances may give some investors pause. Either way, the inclusion of Chinese government and policy bank bonds into global benchmarks will prompt significant inflows into the market from passive funds.

Given global investors’ current paltry allocations to Chinese fixed income, it will be a lengthy process to bring Chinese bonds up to a weight in portfolios that reflects the size of China’s fixed income market. Additionally, the gradual nature of benchmark inclusions—only the most liquid type of government and quasi-sovereigns were added to benchmarks—means that while foreign ownership of the market will rise, it will do so slowly. 

China’s bonds are slowly going global, but global investors have been even slower to include Chinese assets in their portfolios. This may change in the near future, due to the factors discussed earlier, but investors should be mindful that this will be a gradual process likely to stretch on for many years to come.

¹ CEIC, ChinaBond, CSRC, J.P. Morgan Asset Management. Oct. 31, 2019.
² Korea Financial Supervisory Service, Korea Exchange. December 31, 2018. People’s Bank of China. May 31, 2019.
³ J.P. Morgan Economics Research. April 2019. 
⁴ China Bond Connect. October 31, 2019. 
⁵ Bond Connect—A Vibrant May—Bond Connect Investors Hit 900 Mark. May 16, 2019.
⁶ Journal of Banking and Finance. Livingston. 2017.
⁷ IMF Global Financial Stability Report April 2019, JPMorgan Chase & Co, Arslnalp and Tsuda (2014), and IMF staff estimates.