China A-shares: traders want access to onshore funding

Inclusion in MSCI will drive CNH squeeze unless CNY market is opened or settlement extended

Boat outside Hong Kong

Offshore renminbi funding costs are likely to rise following the addition of Chinese mainland shares in two MSCI benchmarks on May 31. In an effort to ease growing pressure on the currency and stem a pending liquidity crunch, global dealers are calling for access to onshore funding and an extension of the same-day settlement horizon on Stock Connect equity trades.

As much as $17 billion could flow into onshore Chinese markets once MSCI includes 234 stocks from mainland China – known as A-shares – into its Emerging Markets and All Country World Index, according to market estimates. Funds tracking MSCI indexes need to raise renminbi in the offshore CNH market, which is deliverable in Hong Kong, in order to invest in A-shares and maintain accurate index exposure following the rebalancing.

“Ultimately, if nothing changes, pressure on CNH will continue to increase. If we have a successful rebalancing and everything goes well, MSCI is going to carry on increasing the representation of China A-shares, and that’s going to put enormous pressure on CNH,” says Barnaby Nelson, head of investors and intermediaries for transaction banking in Greater China at Standard Chartered.

Signs that those flows could reduce the availability of offshore renminbi are already evident. One-year USD/CNH forward rates closed at 6.5215 on May 29 – their highest level in more than three months according to Bloomberg data.

To stave off a liquidity crunch on the first day of inclusion, the Hong Kong Monetary Authority (HKMA), which regulates the market, asked nine banks to act as CNH liquidity providers, allowing them to access a 2 billion yuan repo facility.

While this may help ease short-term pressure on the currency, more fundamental changes might be required once MSCI starts to include a greater slice of the onshore stock market.

Initial MSCI exposure to A-shares will be small. China’s mainland stocks will represent an aggregate of just 0.39% of the MSCI Emerging Markets Index. That will rise to 0.78% in September, while subsequent phases of A-share inclusion could drive exposure – and demand for CNH – higher.

Settlement issues

Much of the pressure CNH faces stems from the unique way Stock Connect – the platform run by the Hong Kong Stock Exchange (HKEX) linking the Hong Kong and Chinese stock markets together – settles trades.

While most stock markets settle trades after one or two days (T+1 or T+2), Stock Connect requires same-day (T+0) settlement, matching the settlement time horizon used on the mainland. Liquidity is tighter when trades need to be settled on the same day than when the parties have one or two days to finalise the transaction.

If we have a successful rebalancing and everything goes well, MSCI is going to carry on increasing the representation of China A-shares, and that’s going to put enormous pressure on CNH
Barnaby Nelson, Standard Chartered

“We are in a unique situation with Stock Connect, as brokers settle with the market and clients separately, and earlier than many are accustomed to,” says Jean-Paul Linschoten, head of China client strategy for equities at HSBC. “As a result, brokers and clients are tapping different liquidity pools. T+0 liquidity in any currency is very different from regular T+2 spot.”

Stakeholders have been exploring the possibility of moving to a T+2 market in an effort to relieve some pressure on CNH. According to Linschoten, the additional infrastructure needed, both offshore and onshore, could deter any change in the settlement horizon. This would include introducing new mechanisms such as a delivery-versus-payment model, which ensures delivery of the shares only takes place once payment has been made.

Linschoten notes that since the participation of foreigners on the A-share market remains fairly small – between just 1.5% and 2.5% on a volatile day – there is little incentive to change something that is working perfectly well for onshore participants. That may change if MSCI inclusion drives up the foreign participation rate.

CNY funding

Another way of taking the pressure off CNH liquidity could be to allow stock trades to be funded through the onshore CNY market instead.

This is the model already in place in the fixed-income market. According to some participants, it is one of the reasons the introduction of Bond Connect in 2017 had only a limited impact on CNH funding costs.

Recreating that settlement model in listed stock markets presents its own challenges, however.

“It was easier to do this with Bond Connect because it was all over-the-counter, while Stock Connect cuts across the central clearing and settlement system used at HKEX,” says Nelson. “The system needs to be able to handle both currencies, and we haven’t heard from the exchange about whether they are able to accommodate this or not.”

HKEX declined to comment on whether CNY could be used alongside CNH for purchasing A-shares, but appeared to rule out shifting away from T+0 settlement in a statement emailed to “Stock Connect follows the ‘home market’ principle [and] T+0 has been adopted for the A-Share market.”

There is now so much sensitivity around CNH, my strong sense is that other mechanisms will be put in place as practically as possible
Barnaby Nelson, Standard Chartered

With the world’s eyes on China opening up and MSCI’s A-shares inclusion in particular, it may only be a matter of time before some of these structural changes are rolled out.

“There is now so much sensitivity around CNH, my strong sense is that other mechanisms will be put in place as practically as possible. The only question is just how fast that can be,” says Nelson.

Stephane Loiseau, head of cash equities and global execution services for Asia at Societe Generale, echoes this, suggesting increased foreign activity in the onshore stock market may force Beijing’s hand.

“I expect the next frontier to be changes in the local market micro structure. For example, we may see a transition in the intra-day volume distribution, an increase in the importance of the closing session, further changes in governance and so forth,” says Loiseau.

In a press release, the HKMA said it would continue to “closely monitor market developments and maintain close communications with the Mainland authorities”.

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