Launch of China “Bond Connect” Intensifies Risk Exposure for Foreign Investors

To much fan­fare, China and Hong Kong launched on July 3 a bond trad­ing link called “Bond Con­nect” that facil­i­tates more wide­spread for­eign investor access to the world’s third largest bond mar­ket – com­prised of some $9 tril­lion in gov­ern­ment, agency, and cor­po­rate debt (with much of the lat­ter issued by state-owned enter­prises).  This new Hong Kong back door into the Chi­nese Main­land debt mar­ket is a “sis­ter scheme” to the “Stock Con­nect” arrange­ments that were forged between Hong Kong and the Shang­hai and Shen­zhen exchanges only a few weeks ago.

When “Stock Con­nect” became oper­a­tional, MSCI decided that the time had come to open its cov­eted Emerg­ing Mar­kets Index to some 222 Chi­nese Main­land com­pa­nies, and there is already talk of nearly dou­bling this num­ber.  It basi­cally forces the $1.6 tril­lion of funds under man­age­ment that tracks this MSCI index to buy Main­land stocks. The same phe­nom­ena will apply here as lead­ing bond indices sign up to the Mainland’s “Bond Con­nect” access door.  (Like its stock coun­ter­part, Bond Con­nect will per­mit global insti­tu­tional investors to bypass com­pli­cated Main­land trad­ing licenses.)

Monday’s launch took place just two days after the visit to Hong Kong of Chi­nese Pres­i­dent Xi to mark the 20th anniver­sary of Hong Kong’s return to Chi­nese con­trol.  Almost imme­di­ately, sev­eral large West­ern firms paid trib­ute to “Bond Con­nect” with early trades, includ­ing HSBC, Stan­dard Char­tered, BNP Paribas, and Cit­i­group.  Gold­man Sachs projects that China’s Main­land bond mar­ket will likely attract some $250 bil­lion in net inflows from abroad, if Main­land bonds are included in just three key bench­marks.  This would be enough to off­set an oth­er­wise per­ilous level of for­eign exchange out­flows from China, now aver­ag­ing about $10–20 bil­lion per month.  For­eign hold­ings of Chi­nese Main­land bonds presently totals about $120 bil­lion (less than 2% of mar­ket share).

Beijing’s debt and equity mar­kets, how­ever, are, at times, influ­enced by inter­ven­tions from the one-party state (ver­sus mar­ket forces).  With risk fac­tors over stan­dards of cor­po­rate gov­er­nance, dis­clo­sure, reli­able sta­tis­tics, risk man­age­ment and the rule of law, these Chi­nese mar­kets will present chal­lenges to for­eign investors, par­tic­u­larly indi­vid­ual investors.

These mar­ket real­i­ties are com­pounded by the asym­met­ric risk to share value and cor­po­rate rep­u­ta­tion that a siz­able num­ber of Chi­nese cor­po­rate bond and equity issuers carry around with them because of entan­gle­ments con­cern­ing a range of secu­rity and rep­u­ta­tional risk fac­tors as well, includ­ing ties to the mil­i­tary, cyber abuses, sanc­tions con­cerns and neg­a­tive accu­sa­tions over labor and human rights, envi­ron­men­tal degra­da­tion, ties to high-risk coun­tries and enti­ties over­seas among oth­ers.  Accord­ingly, the new risk expo­sure gen­er­ated by “Bond Con­nect” (and “Stock Con­nect” before it) should receive proper scrutiny as it is rolled out into the broader mar­kets.