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.