Swap Connect: A new milestone in China’s financial opening-up

Editor’s note: Rick Wen is a Deputy Head of Fixed Income Investment at ICBC Asset Management (Global). The views expressed in the article are the author’s personal views and does not represent that of CGTN.

The People’s Bank of China (PBOC), the Hong Kong Securities and Futures Commission (SFC) and the Hong Kong Monetary Authority (HKMA) on July 4 jointly announced a new mutual access program between the Chinese Mainland and Hong Kong’s interbank interest rate swap markets called the Swap Connect. Swap Connect is expected to launch in six months, subject to regulatory approval.

The new initiative marks the latest milestone in connectivity between China’s financial and global financial markets.

Here’s my take on the significance of the upcoming Swap Connect program:

First, it enhances Hong Kong’s status as the world’s top offshore RMB hub. According to China’s 14th Five-Year Plan, the country will support the Hong Kong Special Administrative Region (SAR) to strengthen its functions as a global offshore RMB hub. To further boost the RMB’s development, more investment vehicles are necessary. The size and depth of Hong Kong’s RMB interest rate swap market traditionally have not been large enough to meet global investor demand compared to the onshore (Chinese mainland) market. The new Swap Connect program allows international investors to hedge their RMB interest rate risks better. That will encourage more investors to use or invest in RMB products.

Second, Swap Connect supports the further opening-up of China’s bond markets. The average daily turnover of the Bond Connect scheme exceeded 31 billion yuan (around $4.6 billion) in April, according to the HKMA. Southbound trading of the Bond Connect was launched in September 2021. The move has provided Chinese mainland institutional investors with a convenient, efficient and secure channel to allocate their assets through the Hong Kong bond market flexibly.

China has the world’s second-largest bond market, but foreign holdings of Chinese bonds are relatively low. According to financial data provider Wind, overseas investors roughly held 1.5 percent of the total issuance in 2015. That number has since risen twofold to 3.15 percent. The more than 150 basis points increase may not seem impressive, but the total issuance size of China’s bond market expanded 2.5 times as well. In absolute terms, that translates into foreign holdings of Chinese bonds surging from 760 billion ($112.6 billion) to 3.95 trillion yuan ($585.3 billion). The increase in holdings mostly came through the Bond Connect program.

Compared to other developing market economies, foreign investors typically hold 10 to 30 percent of the developing country’s domestic bonds, so there is still huge potential for Bond Connect to grow in volume.

Swap Connect solves the challenge of hedging RMB interest rate risk, allowing global investors to better participate in the onshore derivatives market to hedge their interest rate exposures.

Lastly, the Swap Connect will further enhance the Hong Kong SAR’s status as an international risk management center; a target also laid out in China’s 14th Five-Year Plan. The most important tool in managing interest rate risk is the yield curve. It’s hard to price risk without a fully developed interest rate curve. Hong Kong has traditionally lacked a complete curve pricing function for RMB products. This will change as Swap Connect matures, as the onshore interbank derivatives market will be open for overseas investors. Hong Kong’s market liquidity and risk pricing accuracy will improve as a result.

The potential of Swap Connect will be massive. The program will initially begin with Hong Kong and overseas investors accessing the Chinese mainland’s interbank interest rate swap market (northbound trading). However, as the opening of the Chinese mainland’s financial markets deepens, outbound investment needs will bring new liquidity into the Hong Kong market. As an international financial center, Hong Kong is active in G3 currency (U.S. dollar, the euro, and the Japanese yen) and interest rate trading. Mainland institutional investors can easily leverage this existing infrastructure.

Swap Connect also enriches the products it supports. Interest rate risk is one of the most significant financial risks, and foreign exchange risk is important too. I believe currency swaps could also be included in the near future.

Overall, I view Swap Connect speeding up RMB internationalization and strengthening Hong Kong’s status as an international risk management center.