China Comes Closer to Convergence

Hayden Briscoe

An announcement in late July by the Hong Kong Monetary Authority (HKMA) may prove to be a milestone we look back on as the trigger for the next step in the evolution of the offshore renminbi bond market. Effectively, the People’s Bank of China (PBOC) has underwritten liquidity in the offshore renminbi.

As a result of the announcement, the alignment of pricing between China’s onshore and offshore bond markets is set to move much closer, in our view, speeding up the opening of the country’s capital markets and it marks another step toward the internationalization of the renminbi (RMB).

In a nutshell, the pool of liquidity available to participants in the Hong Kong-based offshore renminbi (CNH) bond market will increase dramatically as a result of a refinement to a funding arrangement agreed between the HKMA and the PBOC. This additional liquidity will be available at the onshore Shanghai Interbank Offered Rate (SHIBOR) which, as the chart below shows, is much higher than the offshore Hong Kong Interbank Offered Rate (CNH HIBOR).

The effect of this over time will be to bring valuations in the offshore bond market (which have been relatively high because of the market’s limited liquidity) more into line with those of the onshore renminbi (CNY) market. This will remove an important structural impediment to the internationalization of China’s bond market and its currency. From investors’ perspective, the low-volatility offshore RMB carry trade opportunity will continue to pick up as interest-rate differentials improve.

Profound Implications of a Liberalized Chinese Bond Market

The implications for internationalization are profound. They amount to what is probably the biggest change in global bond markets in our generation. When the RMB is internationalized the Chinese government bond market, capitalized at around US$2.8 trillion, would have a place in all global indexes. It’s the third largest bond market in the world, equivalent to the German and French markets combined. To include the weighting of Chinese government bonds in a traditional market-cap weighted government bond index, investors would be forced to commit 12% of their fixed-income allocation to get to index weight.

A number of developments are taking place in the liberalization of China’s bond markets and currency, of which the latest HKMA announcement is just one. All are incremental and essentially technical in nature, but their cumulative impact is potentially powerful. The HKMA, for example, said that it would use its existing swap agreement with the PBOC to provide authorized institutions in the offshore RMB market (that is, Hong Kong banks) with overnight funds. This would be in addition to the one-week funds already available on a T+1 basis.

To appreciate the significance of the HKMA’s announcement, some context is helpful. Since the CNH market began in July 2010 the “new” CNH currency level has not always traded in line with the CNY currency level. This volatility between the two currencies has gradually eased as a result of regulatory changes, interbank developments and the effect of arbitrageurs.  Today financial market participants, exporters and importers use the two currencies interchangeably.

Despite this, however, the market has continued to worry about the possibility that, in times of stress, the CNH market could fall out of sync with its CNY counterpart because the HKMA did not have unlimited CNH liquidity to be the lender of last resort to the Hong Kong banks. Thanks now to the provision of overnight funds through the PBOC swap agreement, that is no longer the case.

Consequently, the big difference between onshore and offshore interest rates will start to converge as banks arbitrage cheaper funding windows (that is, CNH yields will rise to onshore SHIBOR levels) and the CNH/offshore trade settlement window will continue to grow in importance as exporters and importers settle more physical transactions in RMB.

The PBOC now has 21 RMB bilateral swap agreements with other central banks, totaling $2.2 trillion. The Monetary Authority of Singapore recently became the latest to implement one and the next such agreement is expected to be with the European Central Bank, with a value of $800 billion. Other pointers to the RMB’s eventual internationalization include Taiwan’s move into clearing and trading offshore RMB; the fact that 12% of China’s global trade is now settled in RMB; China’s liberalization of its capital account; increased access to Chinese investment markets for Qualified Foreign Institutional Investors; and permission for Hong Kong-domiciled funds to be sold into China.

In light of these changes, we continue to see great potential in carefully managed investment in China’s bond markets.

 

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.
Hayden Briscoe is Director—Asia-Pacific Fixed Income at AllianceBernstein

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