China on Track with Plan to Open up Financial Markets as Newest ‘Connect’ Program Marks Anniversary

As policymakers are making headway towards the implementation of bond repo access, the most recent component of the internationalisation of China’s financial markets, Swap Connect has just celebrated its first anniversary with the launch of new features and much optimism for its future growth.

The sixth instalment of the Hong Kong Stock Exchange’s “Connect” franchise – which includes the Stock Connect and Bond Connect programs, among others – was launched just over a year ago on 15 May 2023, primarily covering interest rate swaps.

As the world’s first derivatives market-access scheme, Swap Connect allows overseas investors to trade with mainland Chinese dealers and centrally clear and settle renminbi-denominated interest rate swaps without having to adjust their existing trading and settlement practices. Investors can clear trades through Hong Kong Exchange’s OTC Clear and, importantly, under the city’s internationally familiar legal framework.

Over the past year, institutions from global and regional banks to securities firms and investment managers have transacted in the program. Participants hail from all across the Asia Pacific region, as well as from Europe, and have transacted over a trillion yuan ($138 billion) in notional terms via Swap Connect, according to domestic media reporting.

Through 2023, the renminbi-denominated interest rate swaps market grew by 44.1%, the People’s Bank of China (PBOC) said in a report. Swap Connect has provided global investors with a channel to this deeper and more liquid swaps market onshore. It has also facilitated access to more efficient interest-rate hedging tools, as a growing number of global investors begin to participate in China’s onshore bond market, the world’s second largest.

The Swap Connect program gained solid traction, even as market conditions became challenging at times over the past 12 months. International demand for Chinese debt securities fluctuated, broadly in conjunction with monetary policy expectations in developed markets.

Just as the world saw with inclusion of Indian government bonds into globally important emerging-market fixed income indexes beginning in late 2023, China too has reaped benefits from index inclusion of Chinese debt securities in recent years, including lower borrowing costs for the government, as well as for Chinese firms. Foreign investors have added incremental liquidity to the market – playing a different role from local commercial banks, which tend to hold government bonds to maturity – thereby helping to meet the rebalancing needs of passive funds.

As the share of foreign buyers of Chinese bonds builds, domestic institutional investors will be able to redirect capital to areas of greater need, such as toward infrastructure or the energy transition.

On the first anniversary of Swap Connect’s inception, overseas interest in onshore China bonds is again on the rise. Foreign holdings of onshore bonds recovered to 4 trillion yuan as of the end of March 2024, according to data from the People’s Bank of China.

By extension, demand for onshore swaps will also increase, and highly anticipated enhancements to Swap Connect will only contribute to the program’s popularity.

Firstly, global investors have been very eager for International Monetary Market (IMM) dated swaps to be included in the Swap Connect.  These are forward-dated swaps starting on globally standardised dates, the third Wednesday of March, June, September and December. This is a popular feature for investors, as it provides consistency and eases trade-offset for their positions. Investors now also have greater flexibility in customizing their swap start-date to match bond payment dates or other positions.

Meanwhile, overseas institutions have been awaiting an expansion of the existing trade unwind mechanism currently in use in the mainland Chinese swaps market. Many investment strategies, for example, require flexible parameters for unwinding swap trades quickly and efficiently in order to be executed. Over the past year, Chinese regulators have proactively worked to provide solutions tailored to these needs. Because of its importance, however, implementation of this functionality must be done in a robust and thoughtful manner to ensure its successful adoption by the global investor community.  

Furthermore, as China continues to shed the credit-fuelled growth model for a path of higher quality economic growth, tools for effective monetary policy transmission and interest rate management will become increasingly relevant. Derivatives markets are an important part of those mechanisms.

This past January, the PBOC and the State Administration of Foreign Exchange (SAFE) released a consultative document to gauge market views on opening up the onshore repo market, which facilitates short-term borrowing among debt investors, to offshore institutions. The measure would allow all international investors currently participating in the China Interbank Bond Market (CIBM) to access the world’s largest fixed income and money market, according to data from the International Capital Market Association (ICMA).

The will and desire of the world’s second largest economy to meet the needs of global investors has been steadfast and unwavering. A year since the launch of Swap Connect, we have also seen sustained interest among global investors. Chinese markets continue to have low correlation with policy ructions seen in other parts of the world, and will very likely evolve into an important source of diversification for money managers in the foreseeable future.