China's Bond Market Opened Further With QFII Quota Removal

China recently announced plans to remove investment limits under the Qualified Foreign Institutional Investor (QFII) program as part of an effort to open up the domestic bond market to foreign investment.

China's $13 trillion bond market, quadrupled in size over the last decade, is the world's second largest bond market after the United States. So far foreign investors have played a very small role. But as Beijing tries to grapple with a slowing economy and a taxing trade war with the U.S., it is now looking to foreign investments to increase liquidity in the domestic bond market, a primary source of financing for Chinese corporations.

On Sept. 10, the State Administration of Foreign Exchange (SAFE) announced it will cancel the investment quota system under the QFII and, its renminbi-denominated counterpart, RQFII programs. It did not say when the change will come into effect.

"This was a significant development", said Stanley Zhou, a Shanghai-based partner at King & Wood Mallesons. "Most QFII license holders around the world were using up their approved QFII quotas before the new rule was announced."

Previously, qualified foreign fund houses, banks and insurers had to apply for individual investment quotas from SAFE under the QFII and RQFII programs, launched in 2002 and 2011 respectively. This effectively limited how much they could invest through the relevant program.

Before announcing the removal, the government was already relaxing the quotas. Earlier this year, SAFE doubled the total QFII investment quota to $300 billion. Not long after, the China Securities Regulatory Commission (CSRC) relaxed restrictions on the kinds of products that foreign investors can buy and sell. The CSRC draft rules expanded foreign investors' investment scope under the QFII program to include bond repurchases, private funds and derivatives.

The wide range of products available to foreign investors under the QFII program makes it an attractive method for accessing China's bond market, Zhou said. "Because there are so many different products to choose from, foreign investors have more room to choose the types of products that fit their risk appetite and portfolio strategy."

China's bond market suffers from insufficient liquidity as it is dominated by commercial banks which tend to hold bonds to maturity and have low trading frequency compared with institutional investors such as QFIIs. The authorities have looked to foreign investors to mitigate this problem, said Jennifer Zhang, a Beijing-based partner at East & Concord.

"The removal of the QFII quotas supports the development of businesses and helps ease the financing difficulties which most of them are facing." she said.

However foreign investors still play a very small part in China's bond market, accounting for around 2.2% of the market. In Indonesia and Malaysia, foreign bond ownership is at 35% and 25% respectively.

In addition to reforms to QFII, China's bond market consisting of an interbank bond market and an exchange market has seen several other major developments in recent years. Apart from QFII and RQFII, offshore investors have also been allowed access to the interbank bond market through Hong Kong under a bond connect program since 2017. In July, a similar program connecting the bond markets of China and the U.K was mooted. In November 2018, the Ministry of Finance and State Administration of Taxation jointly issued the Circular on the Policy for Enterprise Income Tax and Value-added Tax on Investments in the Domestic Bond Market by Foreign Organizations (财政部、税务总局关于境外机构投资境内债券市场企业所得税增值税政策的通知) which exempted foreign bond investments from enterprise income tax and value-added tax until 2021.

The spate of opening up measures in recent years has led to the inclusion of Chinese bonds in some key global benchmarks. In April, Bloomberg began adding hundreds of onshore Chinese bonds to one of its most widely-tracked indexes, with analysts estimating around $150 billion of foreign inflows into the bond market as a result. Later in September, it was announced that JPMorgan will add Chinese government bonds to its Government Bond Index Emerging Markets index from February 2020 onwards, with FTSE Russell also poised to do the same.

Investors have reacted positively to the latest opening up measures, but many of them are still waiting for implementation of the new rules, Zhou said. The CSRC has said it may publish the conclusion to the consultation for its draft rules issued in early 2019 before the end of the year. For the QFII investment quota removal, SAFE has said it will revise relevant regulations soon but is yet to confirm when this will be done. Zhou believes the revisions will come within the next two months.

"Once there are implementation rules, there will be a real increase in investment in the bond market." Investors are also keeping an eye on how trade negotiations between China and the U.S. pan out, he added.