Chapter

Chapter 11 Clearing Roadblocks to Foreign Participation

Editor(s):
Alfred Schipke, Markus Rodlauer, and Longmei Zhang
Published Date:
March 2019
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Author(s)
LIU Becky

Foreign appetite for renminbi (RMB) assets, including bonds, has regained momentum since the second half of 2017, encouraged by solid economic growth, a better outlook for foreign exchange, and broader access to onshore markets. And the room for further upside is significant. In terms of market development and theoretical accessibility for foreign investors, China’s onshore bond and derivatives markets are at least on par with—or have exceeded—many Asian local currency bond markets that are already included in global bond indices. However, the obstacles are likewise impressive. Accessibility remains weaker than in many peer markets, hindered by technical issues including tax uncertainty, documentation hurdles, the complexity and lack of fungibility across various access pro-grams, and operational issues in onshore foreign exchange transactions.

Total foreign holdings of onshore assets—equities, bonds, loans, and deposits—reached a new high of RMB 4.991 trillion as of the end of September 2018, rising by 64 percent from year-end 2016 levels. Foreigners’ onshore bond holdings reached a new record high of RMB 1.745 trillion, more than double the year-end 2016 level. And global reserve managers have started to diversify their allocations to renminbi—they held a total of US$193 billion of RMB-denominated reserve assets as of June 2018, up 114 percent from the end of 2016 and accounting for 1.84 percent of the total.

Foreign ownership of China’s onshore bond market, however, remains very low, at just 2.1 percent as of September 2018. Foreign ownership of onshore government bonds, at 7.4 percent, is also materially lower than for other special drawing rights currencies (that is, the US dollar, Japanese yen, euro, and British pound), which range from 10 percent to 60 percent. Foreign ownership is expected to rise to 4–6 percent by 2020 (Figure 11.1), and global reserves in renminbi exceed that of the Australian dollar and will likely soon exceed the Canadian dollar.

Figure 11.1.Expected Foreign Ownership of China Bonds by 2020

(Annual net purchase, billions of renminbi; foreign ownership of onshore bonds, percent)

Sources: People’s Bank of China; Standard Chartered Research; and WIND Economic Database (www.wind.com.cn).

Inclusion in global bond indices will boost foreign inflows further. The Bloomberg Barclays index announced in March 2018 that it would include China onshore bonds in its flagship Global Aggregate Bond Index (Global Agg) from April 2019, on the condition that delivery versus payment settlement and block trade issues are resolved and tax treatment is clarified. The probability of similar announcements by the other two major indices—the Global Bond Index– Emerging Markets index and the World Global Bond Index—in 2019 is about 80 percent. Potential foreign passive inflows upon full inclusion in all three indices could exceed US$280 billion.

This chapter identifies the important obstacles foreign investors face in the Chinese bond market and suggests possible solutions. It also discusses areas where foreign investors would like to see further improvements that would allow them to increase their asset allocations to China onshore bonds, including the ability and effectiveness of hedging foreign exchange and rates, better cash bond liquidity, less fragmented bond markets, improved credit risk pricing, and creditor protections.

Roadblocks

Foreign inflows to China’s onshore bond market have been strong in recent months, but several roadblocks continue to prevent foreign participation from reaching its full potential. Most of these are technical rather than regulatory hurdles. These are the same factors that have been identified as preconditions for China onshore bonds’ inclusion in major global bond indices.

The analysis shows that from a regulatory perspective, foreign accessibility to China’s onshore bond, foreign exchange, and derivatives markets is reasonably good. It is superior to several Asian and emerging market local-currency markets already included in major bond indices, such as Malaysia, Indonesia, and Korea (see Table 11.1). After resolution of delivery versus payment settlement and block trades, five other practical issues remain:

1. Unclear tax regulations

2. Hedging capacity and documentation issues

3. Insufficient Treasury bond liquidity

4. Lack of harmonization across all access schemes

5. Ineligibility of nonfinancial corporations under current access programs

Tax Uncertainty: The Biggest Hurdle, by Far

Foreign holdings of China onshore bonds are heavily skewed toward China government bonds (Figure 11.2). Central government bonds made up 61 percent of the total as of the end of September 2018. This strong preference for government bonds, and central government bonds in particular, can be attributed to a high portion of holdings by public sector investors (80 percent of total foreign holdings of China onshore bonds), index inclusion considerations (two out of three major indices will include government bonds only upon China’s inclusion), and tax uncertainty about nongovernment bonds.

Figure 11.2.Foreign Ownership of Onshore Bonds, by Bond Type, 2014–18

Although the Chinese authorities announced a three-year exemption on foreign institutional investors’ withholding tax and value-added tax (VAT) on interest derived from China onshore bond investments on November 7, 2018, insufficient details have been released. Investors are concerned about any potential tax clawback of previous investments before the exemption becomes effective, and also need to have clarity about future tax treatment after the exemption period expires for long-term investments.

Tax issues have real economic implications for investors’ returns and cash flow. Uncertainty about tax rates, tax calculation methodology, and tax collection methodology has materially curbed foreign investors’ interest and ability to invest in onshore nongovernment bonds:

  • Because of uncertain tax liabilities, many investors are restricted from investing in these bonds by their internal risk management teams or compliance departments.

  • For the same reason, most banks are unable to offer products related to nongovernment bonds—such as offering total return swap products backed by onshore negotiable certificates of deposit.

  • Mutual funds with retail investors as end clients are unable to invest in nongovernment bonds, as it is practically impossible to perform tax redistribution (clawbacks) to retail investors if they do (do not) withhold tax payments.

There are three major sources of uncertainty:

  • Ta x rates: The authorities have made no consolidated announcements on the applicable tax rates for foreign investors so far, although it is understood that most tax rates have been released in various documents. The numerous tax regulations—including some very dated ones announced before the launch of the China Interbank Bond Market (CIBM) and Bond Connect programs—and the difficulty of interpreting these regulations, have left big questions about foreign investors’ potential tax rates.

    The situation is similar for panda bonds (Chinese renminbi-denominated bonds from a non-Chinese issuer, sold in China). While international investors broadly expect no tax on their interest income from panda bonds (given that both issuers and investors are foreign in the China context), official announcements to date have made no mention of the tax treatment of panda bonds.

    Table 11.2 outlines the understanding in this chapter of foreign investors’ tax treatment, should there be no tax exemption or when the three-year exemption expires. Although a withholding tax of 10 percent—or lower, subject to double tax treaty—on interest income on nongovernment bonds is the current consensus, no official announcement has been made to support this understanding. Moreover, whether a 6 percent VAT rate is applicable to interest income remains debatable. While it is applicable based on the latest announcement by the People’s Bank of China (Shanghai) in late 2017, it is not the common market understanding. It also remains unclear whether it is fully in line with an earlier release by the Ministry of Finance, which could be interpreted as meaning that all foreign income derived from China’s interbank bond market is exempt from VAT (see “Supplement to VAT Application on Financial Institutions’ Interbank Business” issued by the State Administration of Taxation in June 2016).

  • Tax exemption scope: New uncertainties arose following the Chinese tax bureau’s announcement on a three-year tax break for foreign investors’ onshore bond investments:

    • 1. The definition of bonds that is covered by the tax exemption is unclear. Bonds is a generic concept in China that covers all instruments trading in the fixed income markets, as evidenced by the various reports and statements by the relevant Chinese authorities such as that from the People’s Bank of China and CCDC. However, bonds could be interpreted in a much stricter way internationally, and tax advisors from international accounting firms typically take a narrower definition. Some of them views bonds as only one type of the many “fixed income instruments” or “debt instruments” that are trading in the fixed-income market in the international market. Because the tax exemption is only for bonds, the instruments that are not strictly classified as bonds may not be able to enjoy the same tax exemption.

    • 2. Tax treatment for investments that crosses the three-year tax exemption period is unclear. Investors are unclear how tax treatment will be under the following situations: bonds purchased ahead of the exemption period but matures within the period (for example, investors who purchased a 5-year bond in 2015 that will mature in 2020); bond purchased ahead of exemption period and matures after the period (for example, investors buying a 10-year bond in 2015 that will mature in 2025); bonds purchased during the exemption period but will mature beyond the period (for example, buying a 10-year bond in 2019, which will mature in 2029). It remains unclear whether the tax exemption applies to only interest income during the 3-year period, or based on the purchase date, or based on the maturity date, of the investment. These uncertainties have considerably limited the ability for foreign investors to invest in longer dated instruments.

  • Tax calculation and collection: Aside from tax rates, further details about tax calculation and collection are needed to clarify foreign investors’ tax treatment.

With regard to calculating taxes, it remains uncertain whether taxes on interest income (after the current three-year tax exemption expires) are calculated on a cash basis (that is, deducted from full coupon upon coupon payment) or an accrued basis (that is, deducted based on actual interest income during the bond-holding period).

With regard to collecting taxes, it remains uncertain which entities will perform tax collection, when taxes will be collected, and what the payment frequency will be.

Table 11.1Comparing Foreign Access to Foreign Exchange, Interest Rate Derivatives, and Repo Markets in Select Asian Markets
SpotForward, Foreign Exchange Swap, OptionsCurrency FuturesInterest Rate Swaps, Cross-Currency Swaps, Bond Forward, Forward Rate AgreementsBond FuturesRepo
China1 (currently included in none of the three indices)2Foreign investors can access onshore spot for onshore bond-related investments, but are not allowed to directly trade onshore spot without underlying bonds.Investors can use onshore foreign exchange derivatives to hedge their foreign exchange exposure related to their onshore bond investments up to the tenor and amount of their onshore cash bond holdings. No approval or documentation support is needed, but onshore foreign exchange and derivatives have to be traded through one designated agent.No onshore currency futures market in China.Foreign investors can use onshore interest rate derivatives to hedge their onshore cash bond holdings up to the amount and tenor of their onshore cash bond holdings.Available in China, but not accessible to foreign investors.Available in China, but not accessible to foreign investors (only foreign public sector investors and RMB settlement banks can access interbank repo currently).
Malaysia (currently included in all three indices)Foreign investors can access onshore spot market only if they have an underlying asset.A nonresident institutional investor registered with the central bank is allowed to enter into forward contracts to sell Malaysian ringgit up to 100 percent (or buy Malaysian ringgit up to 25 percent) of its invested underlying Malaysian ringgit-denominated assets and unwind forward contracts without documentary evidence.No onshore currency futures market in Malaysia.Onshore interest rate swaps available for foreign investors as long as they have signed International Swaps and Derivatives Association (ISDA) agreements with onshore banks. They can only do cross-currency swaps with underlying assets, which is requested by regulators. Forward rate agreement market is illiquid.Bond futures are available, but overall market depth is still underdeveloped.Not available to foreign investors, as onshore banks cannot lend money to foreign investors via repo market.
Indonesia (currently included in GBI-EM and Global Agg)Foreign investors can access onshore spot market only if they have an underlying asset. Nonresidents who sell Indonesian rupiah in excess of $25,000 per month for spot are required to provide supporting documents.Trade-by-trade supporting documents are required for nonresidents for all forwards, options, and foreign exchange swaps transactions.No onshore currency futures market in Indonesia.No market.No market.No market.
Thailand (currently included in GBI-EM and Global Agg)Foreign investors can access onshore spot market. Total daily outstanding balances for a nonresident Thai baht (B) account and nonresident Thai baht account for securities each should not exceed B 300 million per nonresident.Nonresidents can buy Thai baht, but the total outstanding balance for each domestic bank cannot exceed B600 million per group of nonresidents. Nonresidents can sell Thai baht, but the total outstanding balance for each domestic bank cannot exceed B 10 million per group of nonresidents.Foreign investors can access US dollar futures onshore.Foreigners can access nondeliverable interest rate swaps [1–10 years) and US dollar/Thai baht cross-currency swaps [require a valid underlying position in domestic securities).No market.No market.
Korea (currently included in Global Agg)Investors can access onshore spot without underlying assets if they open and register nonresident accounts. Further opening of investment account is required for trading financial assets. Notification is required for repatriation in excess of a limit.Supporting documents required for nonresidents for all forwards, options, and foreign exchange swaps transactions to hedge foreign exchange exposure related to onshore bond investments.Foreign investors can access US dollars, Chinese renminbi, Japanese yen, and euro futures to hedge their onshore bond investments.Foreigners can access nondeliverable interest rate swaps [1–20 years), US dollar/Korean won cross-currency swaps [need an onshore Korean won account), and forward rate agreements.Foreigners can access 3-year and 10-year Korean won futures.Yes (as long as they have the bonds).
Philippines3 (currently included in GBI-EM)Foreign investors can access onshore spot market. Bangko Sentral Registration Document issued by the central bank is needed to sell Philippine pesos in the spot market.Foreign investors can use forwards, foreign exchange swaps, nondeliverable forwards, and options to hedge their foreign exchange exposure.No onshore currency futures market in the Philippines.No. Interest rate swap market is very illiquid.No market.No market.
Source: Standard Chartered Research.Note: GBI-EM = Global Bond Index-Emerging Markets; Global Agg = Global Aggregate Bond Index; repo = repurchase; RMB = renminbi.

Foreign public sector investors (central banks, sovereign wealth funds, multilateral) can freely access onshore repo, foreign exchange and foreign exchange derivatives, interest rate derivatives markets (except Chinese government bond futures) without restrictions.

The three indices are JPMorgan Global Diversified Bond Index-Emerging Markets (GBI-EM), World Government Bond Index (WGBI), and Bloomberg Barclays Global Aggregate Bond index (Global Agg).

Philippines US$-denominated sovereign bonds are included in Global Agg, but local currency-denominated Treasuries are not.

Source: Standard Chartered Research.Note: GBI-EM = Global Bond Index-Emerging Markets; Global Agg = Global Aggregate Bond Index; repo = repurchase; RMB = renminbi.

Foreign public sector investors (central banks, sovereign wealth funds, multilateral) can freely access onshore repo, foreign exchange and foreign exchange derivatives, interest rate derivatives markets (except Chinese government bond futures) without restrictions.

The three indices are JPMorgan Global Diversified Bond Index-Emerging Markets (GBI-EM), World Government Bond Index (WGBI), and Bloomberg Barclays Global Aggregate Bond index (Global Agg).

Philippines US$-denominated sovereign bonds are included in Global Agg, but local currency-denominated Treasuries are not.

Table 11.2Tax Treatment for Domestic and Foreign Investors, by Type of Bond
For Domestic InvestorsFor Foreign Investors
CouponCapital GainsCouponCapital Gains
Type of BondIncome Tax + VATIncome Tax + VATWithholding Tax + VATVAT
China government bonds0% + 0%25% + 6.34% for banks’ or funds’ self-owned positions; 0% + 0% for mutual funds; 0% + 3.26% for other funds0% + 0%0%
Local government bonds0% + 0%Same as China government bonds0% + 0%0%
Policy bank bonds25% + 0% for banks’ or funds’ self-owned positions; 0% + 0% for both mutual funds and other fundsSame as China government bonds10% (or lower subject to DTT) + 6.34%0%
Negotiable certificates of depositSame as policy bank bondsSame as China government bonds10% (or lower subject to DTT) + 6.34%0%
Corporate credit bonds25% + 6.34% for banks’ or funds’ self-owned positions; 0% + 3.26% for both mutual funds and other fundsSame as China government bonds10% (or lower subject to DTT) + 6.34%0%
Sources: Ministry of Finance; and Standard Chartered Research.Note: VAT itself is 6 percent, but there is a 12 percent local surcharge on VAT. Therefore, the effective tax rate is 6.34 percent, which is calculated as 6.34% = 1/(1 + 6%) × 6% × (1 + 12%). DTT = double tax treaty; VAT = value-added tax.
Sources: Ministry of Finance; and Standard Chartered Research.Note: VAT itself is 6 percent, but there is a 12 percent local surcharge on VAT. Therefore, the effective tax rate is 6.34 percent, which is calculated as 6.34% = 1/(1 + 6%) × 6% × (1 + 12%). DTT = double tax treaty; VAT = value-added tax.
Suggestions

To resolve these issues, two steps could be taken:

  • Provide sufficient clarifications regarding foreign investors’ current investments: As these are very detailed considerations and more cases may emerge over time, the authorities may consider a question-and-answer format to openly clarify tax treatments for each case, and have the list extended over time. Examples of these cases include tax treatment on zero coupon bonds (such as negotiable certificates of deposit), tax treatment on previous bond investments (for example, tax clawbacks), tax treatment on bonds purchased during the exemption period but that will expire after the period (such as whether interest income will remain tax exempted after the three-year period if a 10-year nongovernment bond is purchased now), and so on.

  • Announce details of further tax treatment when the tax exemption period expires, including tax rates, calculation methodology, and collection methodology: A consolidated confirmation covering all types of bonds and all existing regulations on foreign investors’ tax treatment will be needed to avoid confusion. And such details should be announced well ahead of the tax exemption period. These would allow all relevant parties—including foreign investors, custodian banks, and settlement agents and platforms—to get ready for the change in tax treatment, and ensure a smooth transition. Clarifications in future tax treatments are important to remove investor concerns about their investments in long-dated bonds that expire after the current tax exemption period.

Hedging Capacity in Practice, and Documentation Hurdles

Despite the rapid opening of China’s onshore foreign exchange and interest rate derivatives markets, actual participation by foreign investors remains low. In theory, foreign public sector investors are allowed to access China’s interbank foreign exchange and interest rate derivatives markets without restrictions; and foreign private sector investors are allowed to hedge their China foreign exchange and interest rate exposures in the onshore market, up to the amounts of their onshore cash bond holdings. In practice, however, only some foreign investors are able to access the onshore foreign exchange market, and few can access onshore interest rate derivatives markets at this stage.

Among foreign investors, asset managers—the key users of global bond indices—face the greatest hurdles. The ability to transact at onshore US dollar– to–Chinese renminbi (yuan) (USDCNY) rates (spot, forward, swap, options) are crucial to their investments in China onshore bond markets, as the pricing differences between the USDCNY and US dollar–China offshore spot markets are material. On the other hand, the ability to transact onshore interest rate derivatives, such as interest rate swaps, is considered “good to have, but not a must” at this stage, given that interest rate swaps are less efficient than Treasury bond futures for hedging cash bonds, and the offshore nondeliverable interest rate swap market is trading at similar levels as onshore interest rate swaps. Hence, the lack of practical accessibility to domestic foreign exchange markets is the key hurdle for global bond indices to include China onshore bonds currently.

Foreign Exchange Hedging

There are a number of practical hurdles:

  • The lack of capacity at global custodian banks: Most global asset managers are tied to their global custodian banks for their China bond investments, in particular under the Bond Connect program. But most global custodian banks are not ready to offer onshore foreign exchange transactions at the time of writing, and it is unlikely that the majority of global custodian banks will become ready in the next one to two years. Without operational readiness at the global custodian banks, the vast majority of global asset managers can only fund and hedge their China onshore bond exposure via the China offshore spot market, which has a far smaller funding pool, more volatile liquidity conditions, and usually higher hedging costs.

  • The necessity to sign new International Swaps and Derivatives Association (ISDA) Master Agreements: Most global asset managers need to sign new ISDA agreements with a different subsidiary of their bond settlement agents in order to transact at the onshore foreign exchange market. This is a very time-consuming process, and has considerably delayed the timing of their China bond investments. For example, investors under the CIBM program typically need to sign a new ISDA agreement with the mainland subsidiary of their bond settlement agent, although many investors already have existing ISDA agreements with the banks’ overseas entities. Similarly, investors under the Bond Connect program need to sign a new ISDA agreement with a settlement bank based in Hong Kong SAR, even if they already have an ISDA agreement with the same bank’s other entities (such as a UK subsidiary or a Singapore subsidiary).

  • The unavailability of multiple foreign exchange counterparties: Investors are keen to be able to trade with multiple foreign exchange counterparties to ensure best practice and more efficient pricing. Some even face hurdles in obtaining internal approval to invest in China onshore bonds for this reason. While this is not a determinant for global asset managers to start a position in China onshore bonds, it will definitely be a factor determining whether such investments will be done at scale over time.

  • The lack of clarity for the interpretation of exposure limits: Under current guidance, the exposure of foreign private sector investors to onshore foreign exchange and interest rate derivatives cannot exceed their onshore bond holding positions. While the guideline appears to be straightforward, it is complicated in practice, as there are many ways to interpret it. Questions include whether foreign exchange exposure refers to net or gross exposure, whether foreign exchange forward-forward transactions are allowed, and whether the duration limit is on a bond portfolio or a specific bond. Without clarification from the regulators, market participants usually have to interpret these rules in the strictest possible way, and therefore sharply increase practical hurdles.

For example, exchange-traded fund bond funds commonly hedge expected currency exposure, such as from expected upcoming coupon payments, in advance. This cannot be done under the current guidance because foreign exchange exposure is calculated based on current bond holding positions. But allowing investors to hedge a certain amount beyond their current bond holdings would also create loopholes for investors that only intend to trade onshore foreign exchange without taking cash bond positions. Therefore, the most effective way to resolve such operational issues without creating loopholes is through a positive list outlining permitted behavior based on specific situations.

Interest Rate Hedging

De facto interest rate hedging ability is low for foreign investors in China’s domestic market at this stage, owing to the lack of access to effective interest rate hedging tools (Treasury bond futures), the complexity of documentation, and mixed capabilities under different access programs. Only the CIBM program currently offers access to onshore interest rate derivatives upon signing of a National Association of Financial Market Institutional Investors (NAFMII) agreement. Conversations with international asset managers suggest that it is difficult for them to sign NAFMII agreements due to potential conflicts with their ISDA agreements for other markets. None of the other access programs—including Bond Connect, Qualified Foreign Institutional Investor (QFII), or Renminbi Qualified Foreign Institutional Investor (RQFII)—currently offer onshore interest rate hedging capacity. Accessible derivatives types are generally limited to interest rate swaps and cross-currency swaps, and few can access other derivatives— such as forward rate agreements and bond lending—at this stage. The most effective interest rate hedging tool—onshore China government bond (CGB) futures—is not available to foreign investors under any access program at this stage. And interest rate swaps have not historically been a very good hedging tool for China onshore cash bonds.

The lack of clarity on exposure limits for exchange rate derivatives above also exists for interest rate derivatives. Foreign institutions have to interoperate the general guidance the strictest possible way when no specific guidelines are offered. For example, foreign banks have been conducting onshore interest rate swap hedging on their onshore cash bond holdings issue by issue, with the corresponding interest rate swaps being up to the tenor and notional amount of the specific cash bond. It is practically very difficult to effectively hedge a bond portfolio this way.

Suggestions

To resolve these issues, several steps would be helpful:

  • Establish a centralized foreign exchange registry system to maintain investors’ cash bond and onshore foreign exchange exposure: Such a system would allow foreign investors to trade onshore foreign exchange products with their existing counterparties, by passing the position limit control from the agent bank to the central bank. It will also bypass the current technical hurdles, including global custodian banks’ lack of readiness and the necessity of signing new ISDA agreements with a new counterparty.

  • Allow an overall hedging limit at the investor or product level by combining all positioning under various programs instead of having the position limit calculated based on each program: For example, if a fund product has access to onshore bonds under both the CIBM and Bond Connect programs, exchange rate exposure could be calculated based on combined cash bond positions held under both programs instead of having separate limits for positions under each program.

  • Release a “positive list”’ for foreign exchange and interest rate exposure limits, to provide details on the types of activities allowed under various circumstances: Such a list would greatly increase clarity about what can and cannot be done under the current guidance. It would reduce the need for banks and market participants to interpret the requirements themselves, which has resulted in varying standards across the industry and overly stringent hedging practices. This list should be subject to regular review and additions as real cases emerge in practice.

  • Accept ISDA agreements in addition to NAFMII agreements for private sector onshore interest rate derivatives transactions.

  • Open up onshore China government bond futures to foreign investors for hedging purposes, with exposure limits similar to those for onshore interest rate swaps.

  • Accelerate implementation of Bond Connect to allow access to onshore interest rate derivatives.

Insufficient Treasury Bond Liquidity

A sufficiently liquid secondary market is a key prerequisite for the Chinese government bond yield curve to become a representative benchmark for economic conditions and activity. While on-the-run China government bonds and policy financial bonds are already fairly liquid, gaps between on- and off-the-run bonds are wide (Figure 11.3), and the turnover ratio of China onshore bonds remains low relative to global and some Asian peers (Figure 11.4).

Figure 11.3.China Onshore Bond Turnover, Outstanding Bonds and Turnover Ratio, by Bond Type, 2017

(Trillions of renminbi; percent)

Sources: Standard Chartered Research; and WIND Economic Database (www.wind.com.cn).

Note: ABS/CBs = asset-backed securities/convertible bonds; CGBs = China government bonds; CP/SCP = commercial paper/short-term commercial paper; LGBs = local government bonds; MTNs = medium-term notes; NCD = negotiable certificates of deposit; PFBs = policy financial bonds; PPNs = private placement notes.

Figure 11.4.Global Government Bond Turnover, Outstanding Bonds, and Turnover Ratio, Global and Asian Peers, 2017

(Trillions of US dollars, left scale; percent, right scale)

Sources: AsianBondsOnline; China Central Depository and Clearing Corporation; Deutsche Finanzagentur; Securities Industry and Financial Markets Association; Standard Chartered Research; and United Kingdom Debt Management Office.

The lack of sufficient liquidity in the China government bond market is the second-biggest hurdle for China bonds to be included in global bond indices. Because of liquidity considerations, select global bond indices had suggested including only on-the-run China government bonds at the initial stage, but investor feedback suggests that this leads to frequent rebalancing of the portfolio and losses will be incurred as investors keep switching to new on-the-run bonds when existing holdings become off-the-run.

An improvement in onshore bond liquidity will require further diversification of market participants; further development of interest rate derivatives to allow more hedging and trading strategies, such as developing a liquid swap-spread market; wider participation in the bond repurchase (repo) market; and a less fragmented onshore bond market. While these are mostly long-term issues that will take time to address, two technical adjustments to primary market mechanisms could lead to short-term improvements.

Suggestions
  • Issue more government bonds by retapping existing issues: Authorities could increase primary issuance by reopening existing issues as much as possible, while reducing the number of new issues. They should also consider not only retapping a new issue shortly after issuance but also when it rolls into the next key tenor. This would help maintain the secondary liquidity of existing bonds over time; the relatively large issue size would support secondary liquidity even after the issue eventually becomes off-the-run.

    For example, authorities could retap a 1-year new issue at least three times after the original issuance: after issuance at the 1-year tenor, the issue can be reopened when its tenor reaches 9 months, 6 months, and 3 months (this is how US Treasury primary auctions work). Long-dated bonds, such as the 10-year benchmark, should be retapped many times to keep the bond on-the-run for a longer period of time, and for the issue size to growth to a sufficiently large to be able to retain reasonable liquidity even after it becomes off-the-run.

  • Reduce the number of key tenors: The China government bond curve has a far larger number of key tenors than mature markets, such as US Treasuries. Short- to medium-term key tenors in China include 1-year, 3-year, 5-year, 7-year, and 10-year, while in the United States they are only 2-year, 5-year, and 10-year (although 3-year and 7-year US Treasuries are also issued). Similarly, long-dated China government bond issuance is spread over 15-year, 20-year, 30-year, and 50-year tenors, while the US market has only one key tenor (30-year) and no issuance in any other tenors. Having too many key tenors reduces the focus on each tenor and complicates trading strategies such as curve trades (for example, 10-year/2-year curve steepeners or flatteners), swap spreads (for example, 5-year interest rate swaps against China government bonds), and bonds against futures.

Authorities could gradually align China’s key tenors with global convention by issuing more 2-year notes and reducing 3-year issuance and by moving some 7-year issuance to 5-year and 10-year. At the long end, this could be done by issuing only in the 30-year tenor and scrapping 15-year, 20-year, and 50-year issuance. Reducing the number of key tenors would concentrate activity in the remaining tenors and make these benchmark rates more representative. Investors could still gauge interest rates for the rest of the curve through interpolation for valuation purposes.

Need for Harmonization across Various Access Schemes

The complexity of China’s access schemes and the frequent rollout of new schemes in isolation from existing ones are holding back investment by foreigners, according to feedback from international investors. Multiple access schemes not only create confusion, but also put early movers at a disadvantage—new programs are more flexible than the old ones, and there is no mechanism to transfer from old to new programs. Therefore, many investors prefer to delay investing until they feel that no more new programs will be introduced in the foreseeable future.

Four programs allow foreign investors to access China onshore bonds: QFII, RQFII, CIBM, and Bond Connect (Table 11.3). They vary widely in scope of accessible securities, repatriation rules, and hedging capacity. None of the new schemes were developed based on existing schemes, necessitating separate setup to access each new program.

  • Bond holdings are not fungible across the various programs. Investors with access to more than one scheme cannot merge or transfer their security holdings between different programs.

    • Foreign investors intending to transfer bond holding positions under their QFII or RQFII accounts to their CIBM or Bond Connect accounts usually need to sell the bonds from the old accounts first and buy them back under the new accounts.

    • Bond holdings under the CIBM and Bond Connect programs are also not fungible for investors that have access to both. In particular, foreign exchange and interest rate hedging exposure limits are determined based on bonds held under each program, making it more difficult to transfer bonds across accounts.

    • In addition to requiring operational efforts, such transactions incur real economic costs.

  • The programs differ materially in cross-border repatriation, account setup, and accessibility of onshore bonds, foreign exchange, and interest rate derivatives.

    • Investors can access both the interbank and exchange bond markets under the QFII and RQFII programs, but only the interbank bond market under the CIBM and Bond Connect programs.

    • Investors can access all interbank-traded foreign exchange and interest rate derivatives under the CIBM program within their position limits, but currently only the foreign exchange market under Bond Connect. QFII and RQFII investors just gained access to onshore foreign exchange but still do not have access to interest rate derivatives markets. They can access onshore equity futures, which are unavailable to CIBM and Bond Connect investors.

Table 11.3Comparison of Four Programs for Access to China’s Onshore Bond Market
QFII/RQFII1CIBM DirectBond Connect
RequirementsApproval versus filingApprovalFilingFiling
QuotaYesNoNo
Lock-up requirementsNoNoNo
Product AccessCash Bonds
Interbank
Exchange××
Bond repo×2×
Bond lending××
Bond forward××
Onshore Foreign Exchange
Spot
Forward
Swap
Options
Onshore Interest Rate
Derivatives
Interest rate swaps××
Cross-currency swaps××
Forward rate agreements××
CGB futures×××
Source: Standard Chartered Research.Note: CGB = China government bond; CIBM = China Interbank Bond Market; QFII = Qualified Foreign Institutional Investor; RQFII = Renminbi Qualified Foreign Institutional Investor.

The QFII and RQFII are two separate programs with different eligibility and setup. But the requirements in the above aspects under the two programs are the same.

Overseas public sector investors, overseas participating banks, and renminbi clearing banks have access to the onshore repo market under the CIBM; private sector investors do not have access at this stage.

Source: Standard Chartered Research.Note: CGB = China government bond; CIBM = China Interbank Bond Market; QFII = Qualified Foreign Institutional Investor; RQFII = Renminbi Qualified Foreign Institutional Investor.

The QFII and RQFII are two separate programs with different eligibility and setup. But the requirements in the above aspects under the two programs are the same.

Overseas public sector investors, overseas participating banks, and renminbi clearing banks have access to the onshore repo market under the CIBM; private sector investors do not have access at this stage.

Suggestions

A step-by-step approach to consolidating existing programs and building on existing programs for future relaxation of foreign access is suggested, instead of starting entirely new programs.

  • Allow equal access to onshore securities and derivatives, equal repatriation capabilities, and equal eligibility of foreign investors under existing programs.

  • Set up a mechanism to allow easy transfer of securities holdings across programs, particularly from QFII and RQFII into CIBM and Bond Connect.

  • Build on existing programs when opening onshore capital markets further to foreign investors, and avoid setting up new programs that are completely isolated from existing programs as much as possible. This would likely incentivize foreign investors to set up systems for accessing China’s onshore markets now. Even if they consider the current level of market opening to be insufficient, these investors would enjoy a first-mover advantage on future market opening.

Allowing Nonfinancial Institutions Access to China’s Onshore Markets

Current access programs—including QFII, RQFII, CIBM, and Bond Connect— allow only foreign financial institutions to access China’s onshore bond markets. Conversations with global nonfinancial corporations suggest that they are keen to access the onshore bond market as an avenue for liquidity management. Some of these corporations have started to seek indirect access to the onshore bond market, for example, by setting up segregated accounts with an asset manager or via structured products such as total return swaps.

In addition, this restriction for participation by nonfinancial institutions has also led to unnecessary additional documentation requirements for applicants that are financial institutions. Conversations with investors and agent banks suggest that many applicants are struggling to provide supporting documentation for proof of being a financial institution, and that this has led to material delay and additional complications at the application process for both the CIBM and Bond Connect programs.

Suggestion

Broaden the scope of eligible foreign investors to include nonfinancial corporate institutions. This would provide an effective channel for corporations to deploy and retain renminbi funds derived from their China business without converting back into other currencies. This would not only lead to greater foreign inflows but would also broaden renminbi usage over time. Compared with financial institutions, corporations are usually less speculative and longer term in their investment behavior.

Areas for Improvement in Domestic Products

This section discusses areas for potential further improvement in China’s domestic bond and derivatives markets. We believe these improvements would make China’s capital markets a better place for fundraising and investment and facilitate stronger and more sustainable foreign asset allocations. The focus is on the following areas:

  • Reducing the fragmentation of the bond market

  • Correctly pricing credit default risk and improving creditor protection

  • Further developing the interest rate swap market

  • Improving the effectiveness of credit default risk hedging

Reducing the Fragmentation of the Bond Market

Market fragmentation has historically been a key hurdle to foreign investor understanding of and investment in China’s onshore bond markets. Harmonization of rules and accessibility between the interbank and exchange bond markets is much needed. Notable differences exist between the interbank and exchange markets in market rules and participants. This fragmentation leads to unnecessary market complexity, creates room for regulatory arbitrage, and weakens the pricing power of benchmark yield curves.

  • Credit bond issuance rules vary across issuance programs under different regulators, and the bonds are traded in different markets.

  • Two repo markets operate in parallel in the interbank and exchange markets, with different trading mechanisms, counterparty risks, eligible participants, and haircuts.

  • Fungibility between bonds trading in both markets is lacking. Only government and enterprise bonds can be traded in both markets, and moving bonds between the two markets is not straightforward.

  • The supply-demand dynamics of the two markets are completely different, leading to different pricing for the same bonds in the two markets, and resulting in two different CGB yield curves.

Suggestion

Authorities could harmonize credit bond issuance programs across the various existing schemes—the enterprise bond program under the National Development and Reform Commission; the short-term commercial paper, commercial paper, and medium-term notes program under the NAFMII; and the corporate bond program under the China Securities Regulatory Commission—by setting the same issuance rules and allowing all bonds to be traded in both the interbank and exchange markets. Meanwhile, regulators could improve fungibility between the two markets by allowing the smooth transfer of bonds between them. Finally, authorities could either combine the various CGB yield curves or eliminate the less liquid ones and publish only one CGB benchmark yield curve to make it more representative and less confusing.

Pricing Credit Default Risk Correctly and Improving Creditor Protection

A mature credit bond market is not characterized by having no defaults. It means that a framework is in place that provides correct pricing of credit default risk, effective creditor protection, and an established mechanism to handle defaults. While credit bond defaults have started in China in recent years, there is no established framework for debt structuring or issuer liquidation. Similarly, while some bond covenants—such as cross-default clauses—have been put in place for selected new issues, the covenants remain light relative to international peers and do not provide sufficient protection to creditors in their current form.

Table 11.4China’s Domestic Credit Rating Agencies
Market Share (%)Regulatory Approvals
AgencyBy bonds outstandingBy number of issuersNAFMIICSRCNDRCCIRC
China Chengxin Securities Rating3024
China Chengxin International Credit Rating
China United Ratings2821
China Lianhe Credit Rating
Dagong Global Credit Rating2314
Shanghai Brilliance Credit Rating814
Pengyuan Credit Rating820
Golden Credit Rating36
China Bond Rating CorporationNANA
Sources: Standard Chartered Research; and WIND Economic Database (www.wind.com.cn).Note: CIRC = China Insurance Regulatory Commission; CSRC = China Securities Regulatory Commission; NA = not available; NAFMII = National Association of Financial Market Institutional Investors; NDRC = National Development and Reform Commission.
Sources: Standard Chartered Research; and WIND Economic Database (www.wind.com.cn).Note: CIRC = China Insurance Regulatory Commission; CSRC = China Securities Regulatory Commission; NA = not available; NAFMII = National Association of Financial Market Institutional Investors; NDRC = National Development and Reform Commission.

The credibility of the local credit rating system has been questioned by international investors, as domestic ratings are heavily skewed toward the upside, offer insufficient credit differentiation within each rating category, and do not provide red flags before actual defaults. For example, some issuers’ local credit ratings were still rated AA before they announced missed payments. China’s current set of domestic credit rating agencies is described in Table 11.4.

Aside from the historical lack of real defaults, these issues also result from the current market and regulatory framework:

  • Excessive competition in the credit rating industry: China has too many credit rating agencies. At least eight domestic rating agencies are recognized by one or more regulators, compared with just three widely recognized rating agencies internationally. Investors see little differentiation among these agencies in credibility; issuers also do not differentiate between them as long as they are eligible to provide ratings under the issuer’s targeted bond issuance program (Table 11.5).

    The large number of eligible institutions and the issuer-paid credit rating model may result in an upwardly skewed credit rating distribution aimed at securing mandates, with eligible institutions offering higher ratings.

  • High regulatory rating requirements for credit bond issuance: Given high credit rating requirements for domestic credit bond issuance, low ratings (AA- or below) are essentially useless in China—issuers with low ratings are unable to issue bonds under most existing bond issuance programs. For example, the China Securities Regulatory Commission requires a rating of at least AAA for public bonds issued to all investors; NAFMII requires a minimum rating of AA for short-term commercial paper issuers (Figure 11.10).

Table 11.5Rating Requirements for Issuers
RegulatorBond TypeRating Requirements for Issuance
NAFMIIShort-term commercial paperTo register for issuance, corporations must provide two issuer credit rating reports by different agencies, with at least one rating of AA or above.
Commercial paperIssuer is required to be rated AA- or above.
Medium-term notesIssuer is required to be rated AA- or above.
Special caseIssuers in the property sector must have listed A-shares and be rated AA or above.
NDRCEnterprise bondsCompulsory explicit guarantee required for issuers of local government financing vehicles with debt-to-asset ratios of 65 percent or above, except AAA issuers with debt-to-asset ratios below 75 percent, and AA+ issuers with ratios below 70 percent.
Compulsory explicit guarantee is required for general corporate issuers with debt-to-asset ratios of 75 percent or above, except AAA issuers with ratios below 85 percent and AA+ issuers with ratios below 80 percent.
Issuance is eligible for fast-track program if (1) issuer or issue is rated AAA; (2) it is guaranteed by a company rated AA+ or above; (3) bonds are rated AA+ or above and are guaranteed or pledged by valid assets; or (4) issuer is rated AA+ and has a debt-to-asset ratio below 20 percent.
CSRCCorporate bonds Only AAA rated bonds can be issued to all investors (including retail investors).
Special caseIssuers in the property sector must be rated AA or above.
Sources: National Association of Financial Market Institutional Investors (NAFMII); National Development and Reform Commission (NDRC); China Securities Regulatory Commission (CSRC); and Standard Chartered Research.
Sources: National Association of Financial Market Institutional Investors (NAFMII); National Development and Reform Commission (NDRC); China Securities Regulatory Commission (CSRC); and Standard Chartered Research.

This suggests that no issuers will accept an initial rating below AA-, thereby limiting the range of acceptable ratings to four notches at best— namely AAA, AA+, AA, and AA-. This is in contrast to the 16-notch scale in the international market, ranging from AAA to B- for most issuers (few issuers are assigned initial CCC category ratings).

Suggestion

Authorities could standardize the eligibility of rating agencies across regulators, reduce the number of eligible rating agencies, and remove credit rating requirements for issuance across all programs. These steps would reduce issuers’ scope to select between agencies and widen the range of eligible and acceptable credit ratings to allow greater credit differentiation. Less intense competition would reduce the need to offer inflated credit ratings, improving rating agencies’ credibility over time. The removal of rating requirements at issuance would allow more room for credit differentiation. It is the view here that all issuers should be allowed to issue; whether such issuance can successfully come to the market should depend on whether credit risks are correctly priced in and the borrowing terms offer sufficient creditor protection. Investors rather than regulators should determine both.

Further Developing the Interest Rate Swap Market

China interest rate swaps are among the most popular products for investors to express views on the direction of China’s interest rates and manage interest rate risk. However, the large number of floating-rate legs and the lack of direct linkage to financing costs in the real economy have hindered the development of this market.

The China interest rate swaps market has many more floating-rate legs than most G10 markets. Compared with the typical floating-rate legs of 3-month London interbank offered rate (Libor) or 6-month Libor in the US market, China has interest rate swaps based on the following floating-rate legs:

  • 7-day repo fixing for transactions across all financial institutions

  • 7-day repo fixing for transactions among deposit-taking institutions

  • 3-month Shanghai interbank offered rate (Shibor)

  • Overnight Shibor

  • People’s Bank of China benchmark deposit rate

  • People’s Bank of China benchmark lending rates

  • Loan prime rate

However, the pricing of assets and liabilities in China’s financial system is not yet based on interbank rates (such as Shibor). Banks’ liabilities are determined by a combination of the policy rate (People’s Bank of China [PBC] benchmark deposit rate) and interbank rates (PBC open-market operation rate, medium-term lending facility rate, secondary 7-day repo rates). Corporate liabilities are mostly benchmarked against PBC benchmark loan rates; no loans are priced over 7-day repo rates and few are priced over Shibor or loan prime rates.

Despite the large number of floating-rate legs, there is no natural need for banks to swap from fixed-rate assets into floating-rate assets, or for corporations to swap from floating-rate loans into fixed-rate loans—the key function of interest rate swaps in the real economy.

Suggestion

Authorities could focus on developing just two interest rate swaps markets, namely 7-day repo and 3-month Shibor-based interest rate swaps, and gradually eliminate additional curves. Further liberalization of interest rates will likely lead to a gradual shift of banks’ funding costs to interbank from retail deposit rates. This is likely to result in a gradual shift of bank loan pricing from current PBC benchmark lending rates to an interbank rate, most likely 3-month Shibor. The availability of liquid 7-day repo and 3-month Shibor-based interest rate swaps markets would be key in making it easier for banks and corporations to swap between fixed- and floating-rate assets and liabilities.

Figure 11.5.Breakdown of China Interest Rate Swap Turnover, by Type of Floating Leg, 2008–18

(Trillions of renminbi)

Sources: Standard Chartered Research; and WIND Economic Database (www.wind.com.cn).

Note: FR07 = 7-day repo fixing for transactions across all financial institutions; Shibor = Shanghai interbank offered rate.

Improving the Effectiveness of Credit Default Risk Hedging

China’s regulators have introduced various credit derivatives in the onshore market since 2010, but market development has been very slow. Credit default mitigation was introduced in 2010, and China’s credit default swap (CDS) market was introduced in September 2016. An active CDS market not only offers effective tools for credit risk management, but also facilitates credit pricing discovery. Several fundamental issues have hindered the development of this market:

  • There are no standardized contracts: Currently, only primary dealers are eligible issuers of “certificate-based” credit derivatives, including credit risk mitigation warrants and credit-linked notes. All other market participants can either buy such certificate-based credit protection or enter into bilateral agreements for “contract-based” credit protection that are not tradable in the secondary market, such as CDS and credit risk mitigation agreements. Many of China’s CDS contracts target a specific debt issue, rather than an issuer. There also exist no standardized contracts at this stage. Comparatively, international CDS contracts are usually issuer based, and standardized (such as 5-year China sovereign CDS). The issue-based nature and the lack of a standardized format have led to a lack of liquidity in the secondary market, preventing pricing discovery and reducing both the demand and the supply of credit derivatives products.

  • The definition of credit event is vague: Existing guidelines do not specify triggers for credit events. The lack of bond covenants, such as cross-default clauses (which remain uncommon despite having been introduced in recent years) and well-established default and liquidation procedures, creates further complications. These uncertainties further reduce the incentive to buy credit protection.

Suggestion

Focus on standardized credit derivatives contracts that are issuer based (rather than issue based) and that can be easily traded in the secondary market, similar to the 5-year CDS contract in the international market. A mechanism should be created to ensure ongoing issuance of on-the-run contracts (for example, issuing a new 5-year contract every half year) and allow easy transition from off-the-run contracts to on-the-run ones (for example, by paying a spread).

The availability of standard and issuer-based contracts would ensure ongoing liquidity availability and comparability for these products and would likely boost activity in the secondary market. An active secondary market is crucial for price discovery, and is fundamental for a material increase in both supply of and demand for credit derivatives in China. It greatly increases banks’ and investors’ incentives to trade credit protection, even when there is no imminent default risk.

Conclusions

The key hurdles to foreign investors’ access to China’s domestic bond market are practical rather than regulatory. Resolving these issues in a timely manner, while avoiding introducing new uncertainty and practical hurdles as capital markets are opened further, is crucial to securing international investors’ commitment to China’s capital markets.

This chapter suggests that the authorities place greater importance on practical and operational considerations, in addition to capital market and regulatory issues, in future policymaking. The authorities should aim to ensure that practically viable solutions are available upon further opening of capital markets, or at least provide an interim solution. The authorities might want to consider the benefits of broadening the dialogue with market participants, particularly intermediaries such as commercial banks and global custodians, to identify practical issues and arrive at operational solutions as they open up domestic capital markets further.

Specific rules and guidelines for what can and cannot be done would provide more clarity and reduce room for interpretation by the industry. In the current increasingly stringent regulatory environment, general guidance is interpreted as strictly as possible by market participants, making it difficult—if not impossible— to perform investment and hedging activities. To resolve these issues, it would be useful for the PBC to publish positive lists of the practices allowed under each scenario based on real business cases, and update the lists regularly as new cases emerge. In addition, the authorities could publish case studies to clearly illustrate the required processes for application, investment, repatriation, and hedging. Experience shows that case studies are among the most effective tools for clarifying rules and procedures, leading to faster take-up by the industry. To minimize start-up costs, the authorities might consider building upon existing platforms when further opening up domestic markets.

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