China expands foreign access to swaps after $130 billion bond sell-off

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China has opened the door for more foreign investors to access its prized $5 trillion interest rate swap market, a move Beijing hopes will help stem a protracted sell-off in domestic debt with the US rate hike.

The market link, known as Swap Connect, was launched on May 15 and is similar to existing programs in Hong Kong that allow offshore investors to trade bonds and titles in Shanghai and Shenzhen.

Eddie Yue, chief executive of the Hong Kong Monetary Authority, said during a meeting in Beijing that allowing foreign investors to hedge interest rate risk on their renminbi bonds “can prevent steep bond selling, reduce the volatility of the market and improve financial stability”. .

Enrico Bruni, head of the Europe and Asia business at Tradeweb, a bond trading platform, said “the most direct impact is access to a liquidity pool that was previously untapped.”

But while investors have welcomed the new channel for onshore derivatives trading, few expect it to reverse as long as the US Federal Reserve continues to pursue aggressive policy. monetary tightening campaign.

Foreign investors using Hong Kong’s Bond Connect program have offloaded some Rmb 220 billion ($31 billion) of Chinese government debt this year, bringing total outflows to more than Rmb 903 billion ($130 billion) since the beginning of 2022.

Outflows accelerated as repeated rate hikes by the Fed pushed US Treasury yields above their Chinese counterparts.

“The outflows from the Chinese market are not due to the fact that [investors] have access to a certain pattern,” said a senior analyst with a data provider on the bond market in Asia. “This is [caused by] central bank interest rate divergence.

Data released by the China Foreign Exchange Trade System (CFETS), a central bank affiliate that manages the country’s interbank market, said 27 offshore investors – including HSBC, Deutsche Bank, BNP Paribas, Amundi, Citigroup, Maybank, DBS and Standard Chartered – traded swaps worth around Rmb 8.3 billion on the first day of the programme.

This was less than half of the program’s total daily quota of Rmb20 billion, which is divided among the participating financial institutions. But the Hong Kong head of financial markets for a large European lender said initial demand was encouraging and that his team was already close to meeting its daily quota after executing transactions for about half a dozen clients.

A Shanghai-based banker at a European lender said trading has been “tepid” since launch. He warned that there were “many operational issues to address and sort out”, describing initial trading as still in “test mode” with technical issues and liquidation hitches.

Despite such teething problems, there was broad consensus that the new trading scheme was critical to the continued integration of Chinese and global finance.

“Swap Connect is an important step for the [Chinese central bank] and China in opening up its financial market,” said Chen Xinquan, an economist at Goldman Sachs.

Chen said the new scheme is vital for foreign investors using Hong Kong’s popular Bond Connect scheme, which accounts for about 60% of foreign exposure to the renminbi-denominated government debt market.

While interest rate swaps with shorter maturities had ample liquidity, he said, trading activity for swaps with maturities between 5 and 10 years was thinner, which made it harder for offshore investors to hedge long-term interest rate risks.

International investors, Chen added, “definitely have exposure to both short-term and long-term bonds, with [funds] and real money very interested in longer-term debt”.

However, he said 10-year government bond futures, which are not yet included in the program, are “more effective hedging tools” for investors with exposure to longer maturities.

The head of a group in the financial sector was more forthright: “What investors really want access to is bond futures.”

Beijing has been reluctant to give foreign traders more access to its onshore government bond futures for fear they might disrupt the market, which, while more liquid than that of offshore bond futures, is relatively shallow in absolute terms.

However, some traders believed that China would quickly open up its bond futures market now that the Swap Connect scheme had been launched.

“Our expectation is that it won’t be that difficult [for the programme] to expand into the longer term, 7 to 10 years, where liquidity is much deeper than offshore,” said the Hong Kong finance chief at a European investment bank.

Furthermore, analysts had expected that Swap Connect would facilitate more inflows for the Chinese renminbi debt market once Chinese bond yields finally returned above those of US Treasuries.

“Demand for the swap scheme is likely to increase going forward, especially as the rate environment calls for higher inflows into Chinese government bonds,” said Chen Jianheng, head of fixed income research at brokerage group China International Capital corporation.