China to launch Swap Connect with Hong Kong in half a year

China will allow international investors to access its interest rate derivatives market through Hong Kong, giving foreign funds a new tool to hedge their holdings in Chinese bonds.

According to a statement from the People’s Bank of China and the Hong Kong authorities, Swap Connect will begin in half a year after receiving regulatory approvals, market readiness and completion of operational activities. Based on data from the Hong Kong Monetary Authority, this will help investors manage the risks of investing in bonds on the mainland.

“By allowing more risk management tools, it makes onshore bonds more attractive to hold,” said Alvin T. Tan, head of Asia FX strategy at RBC in Singapore, “Building up this capability is very important to increase the attractiveness of Chinese fixed income securities.”

The innovation strengthens Hong Kong’s role as a portal to China’s markets. The city is also working to introduce quarantine-free travel for Chinese travelers, even as the business community calls for a wider relaxation of the rules.

Overseas investors increased their holdings in Chinese bonds to 4 trillion yuan ($598 billion) at the end of 2021, about 3.5% of total outstanding bonds, while total onshore interest rate swap trading volume last year was 21 trillion yuan.

International traders will find a more accurate investment hedging tool that matches currency risk and onshore repo rates than the non-deliverable interest rate swaps they currently use, said Ken Chung, chief Asia FX strategist at Mizuho Bank.

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Initially, only northbound trading will be allowed, which means that foreign investors can trade interest rate swaps on land, but not vice versa. Over time, southbound trading will be possible, which allows mainland investors to trade offshore contracts.

According to the statement, other derivatives may also be included in the agreement depending on market conditions. China will also increase its currency swap with Hong Kong to 800 billion yuan from 500 billion yuan, the People’s Bank of China said in another statement.

At the same time, more than 80 exchange-traded funds listed in Shenzhen and Shanghai are eligible to be traded by Hong Kong investors starting Monday, and four Hong Kong ETFs are eligible to be traded by investors in China.

“From a global asset allocation perspective, the connect programs have made the Chinese market more investable,” said Xu Meng, executive director of quantitative investing at China Asset Management Co. “These will enhance the attractiveness of Chinese assets.”