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Awaiting the Swap Connect
China’s deepening financial linkage between Hong Kong and the mainland
- China is due to launch the Swap Connect, which will be the sixth Connect scheme deepening the financial linkage between Hong Kong and mainland China
- Foreign investors will gain access to onshore interest rate swaps, which are more effective interest rate hedges for onshore bonds than offshore swaps
- Mainland China investors could obtain access to Hong Kong’s swap market at a later stage
And then there were six
Since 2014, there have been five Connect schemes launched to deepen the financial linkage between mainland China and Hong Kong. These include the Shanghai-Hong Kong Stock Connect, the Shenzhen-Hong Kong Stock Connect, the Northbound Bond Connect, the Wealth Management Connect and the Southbound Bond Connect. The next instalment is the Swap Connect, which will be the sixth Connect scheme, and allow foreign investors easy access to the onshore interest rate swap market via a quota system. At a later stage, mainland China investors may be allowed to access the interest rate swap market in Hong Kong.
The People’s Bank of China (PBoC) released draft rules for the Swap Connect on 17 February 2023, and initiated a public feedback period on the rules, which ended on 4 March 2023. While we await more details on the official launch date and the quota size, it is worth considering the benefits of accessing the onshore interest rate swap market.
The annual volatility of onshore interest rate swaps has been lower than offshore interest rate swaps in eight out of the last ten years and from a portfolio manager’s perspective, interest rate hedging for a bond portfolio is more effective with onshore interest rate swaps due to the higher correlation with onshore bond yields. The availability of a multitude of interest rate swap curves in the onshore market also means that investors can take more active positions to express views on different funding rates. We introduce the onshore interest rate swap market in this note, discuss its benefits for investors and take the opportunity to update on the trading activity at the Bond Connect.
Timeline of Connect schemes between mainland China and Hong Kong | |
|---|---|
Cross-border Connect Schemes | Launch date |
SH-HK Stock Connect | 17-Nov-2014 |
SZ-HK Stock Connect | 5-Dec-2016 |
Northbound Bond Connect | 3-Jul-2017 |
Wealth Management Connect | 10-Sep-2021 |
Southbound Bond Connect | 24-Sep-2021 |
Source: HKMA, HSBC
Benefits of accessing the onshore interest rate swap market
More efficient interest rate hedge for onshore bonds
Compared to offshore interest rate swaps, onshore interest rate swaps are less volatile and correlate better with onshore bond yields. This makes onshore interest rate swaps more efficient interest rate hedges of onshore bonds. Offshore swaps are more volatile as the trading activity is dominated by offshore participants, who are influenced not just by developments in China, but also swings in global risk sentiment. Comparatively, onshore swaps are largely traded by onshore participants, who typically manage a China-only mandate. Since 2019, the monthly average rolling correlation between 5yr onshore repo1 interest rate swap2 (IRS) and 5yr government bond yields has ranged between 65% and 99%
Active risk management on funding rates
The other benefit of entering the onshore swap market is having access to the Shanghai Interbank Offered Rate (SHIBOR) interest rate swaps, which are rarely quoted in the offshore market.
For the unacquainted, SHIBOR is an uncollateralised wholesale interest rate benchmark in China. There are 18 banks on the SHIBOR panel and the daily fixing is calculated by averaging the quotations, after removing the four highest and four lowest quotations.
Funding rate turns are typically sharper in 3-month SHIBOR than 7-day repo. This phenomenon is anchored in the fact that the central bank conducts daily open market operations using its 7-day reverse repo tool, while there is no daily facility for 3-month funding. There is, therefore more effective policy control over the 7-day rate, than the 3- month rate. Take, for example, during the financial deleveraging episode in 2017, 3-month SHIBOR rose by much more than the 7-day repo rate. Being able to access the onshore SHIBOR curve would allow offshore investors to have an additional instrument to express their views on funding rate turns in China.
Arbitrage trading
Having access to both onshore and offshore interest rate swaps would allow investors to engage in interest rate arbitrage trading opportunities.
As mentioned earlier, offshore interest rate swap trading is dominated by offshore participants, who are influenced by swings in global risk sentiment. Alongside the tendency for offshore participants to get more bearish on China’s growth outlook than onshore counterparts, we have historically seen 5yr offshore IRS trade meaningfully below 5yr onshore IRS. Investors with access to both markets would be able to position for reconvergence of the spread whenever significant divergence emerges, though such opportunities may become more subdued as more investors engage in such trading.
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1 Repo rate is the rate at which the central bank of a country (i.e. the PBoC in the case of China) lends money to commercial banks in the event of any shortfall of funds.
2 An interest rate swap (IRS) is a derivative contract, agreed between two counterparties, that involves an exchange of payments benchmarked against an interest rate index between the two parties.
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