Why foreign investors still face China bond roadblocks

China may have made it easier for foreign investors to access its interbank bond market with the launch of its Bond Connect scheme, but many remain frustrated about settlement issues and a lack of connectivity between onshore and offshore repo markets, an industry conference heard on Tuesday.

Introduced in July last year, Bond Connect allows foreign investors to trade Chinese bonds without setting up an onshore account. 

However, those trades are settled on a delivery-against-payment basis at China Central Depository and Clearing, a state-owned clearing house. That means cash and securities are not settled at the same time, making some investors nervous about the counterparty risk involved. 

This arrangement increases counterparty risk for international investors, Arnaud Delestienne, executive vice-president of Clearstream, one of the world’s largest clearing houses, told the 300-strong audience in Hong Kong.

In developed debt markets, settlement is usually done on a real-time delivery-versus-payment (DVP) basis, which ensures cash payments are made prior to, or simultaneously with, the delivery of the security.

But foreign investors using the Bond Connect route are having to wait as long as several hours to clear their trades, delegates heard.

That could soon change, some market participants hope. George Sun, head of FX and local markets institutional sales for Asia-Pacific at BNP Paribas, said DVP should be coming in the next few months, without specifying what he was basing that assertion on.

But speaking to FinanceAsia on the sidelines of the conference, Delestienne said the settlement issue was proving a major roadblock stopping thousands of Luxembourg- and Dublin-based funds from investing in the Chinese debt market.

“The European regulators have told the Ucits-registered funds to decide whether they want to bear the settlement risk by themselves,” said Delestienne, who declined to provide further details of the discussions under way between European regulators and Ucits fund managers.

Ucits stands for Undertakings for Collective Investment in Transferable Securities and are a type of fund prevalent in the European Union.

NO REPO TO LIVE UP TO

Investors using Bond Connect also have no means to pledge their holdings to international or domestic repo markets, which has curbed liquidity in the secondary market and limited the ability of investors to juice up their returns.

In an overseas repo market, government bond investors can sell their securities to a lender and repurchase them at an agreed price in the future, providing short-term liquidity to the financial market and offering an additional return to the bond holder. Investors can also pledge the government bonds as collateral for a financial institution and extract additional income that way as well.

“Under the Bond Connect, there is the kind of segregation by the beneficial owners coming with a no-transfer rule, which definitely is an impediment to spur interest from foreign investors,” said Delestienne, who has been lobbying Chinese regulators for years to comply with overseas practices.

“The model has been most successful in terms of attracting foreign investors because it is the simplest one for them to deal with and people can refinance their assets in a global management programme, which will benefit the local Chinese market because of an increase of foreign participation,” said Delestienne, who is based in Luxembourg.

The point was echoed by BNP Paribas's Sun, who said Chinese regulators should provide other funding channels to foreign investors such as domestic repo markets.

The opening of the domestic bond market to foreign investors is a critical step for Beijing to promote the renminbi as an internationally accepted currency, challenging the US dollar’s dominant position as a reserve currency.

At $12 billion, China’s debt market is already the world’s third-largest behind the US and Japan and is set to become the second-largest later this year.

Foreign holdings of renminbi bonds, though, remain tepid at less than 2%.

“Expanding at 19% annually in the past few years, China’s debt market is too big to ignore and will reach $50 trillion by 2025 under our assumption,” Dariusz Kowalczyk, a senior economist and strategist for Asia ex-Japan at Credit Agricole, said.