China is expanding access to the $232 trillion repo market in a transformative way, signaling implications for interest rates, analysts say

Turnover in China's interbank repo market, dominated by pledged repo transactions, has skyrocketed over the past decade. These contracts rose by 21 percent According to the central bank, it will rise to 1,668 trillion yuan ($231.8 trillion) in 2023. Overnight repo trades accounted for 88 percent of volume last year, while seven-day contracts accounted for 9.9 percent of volume.

“Opening onshore repo operations is seen as the last mile in liberalizing a country's capital flows,” said Ju Wang, head of FX and rates strategy for Greater China at BNP Paribas. “Essentially you are opening up your money market and the financing of your currency to foreigners. This typically requires much less control of the currency and a much more liberal exchange rate regime.”

A repurchase agreement or repo is a contract to sell a security with an agreement to repurchase it at a specified price in the future. The seller receives funds at lower rates than elsewhere, while the buyer receives an attractive return on the collateral, typically in the form of short-term, collateralized and liquid instruments.

A liquid repo market is a key element of a liquid bond market and is considered essential for market participants, particularly commercial banks, that rely on wholesale financing.

The Hong Kong Monetary Authority will add yuan bonds issued by the Chinese government and political banks as eligible collateral under its RMB liquidity facility from February 26. Photo: SCMP

“The initial feedback from the market has been generally positive,” said Kenneth Hui, chief executive of the Hong Kong Monetary Authority. “For the first time, it will enable more foreign investors, including Bond Connect participants, to conduct onshore repo transactions to obtain liquidity at a lower cost.”

The gradual opening of the onshore repo market will meet offshore market participants' growing needs for financing and liquidity management as they increase their allocation to the onshore bond market, Hui said in a written response to the Post.

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In a precursor to Beijing's repo push, the HKMA will tweak its RMB liquidity facility by adding Chinese government bonds and state-owned bank bonds to the list of eligible collateral effective February 26. This would be the first time that these yuan-denominated notes have been accepted for such purposes in an offshore market.

The inclusion of these bonds “is the first step of our joint efforts with the PBOC and relevant mainland authorities to promote onshore bonds as widely accepted securities in international markets,” Hui said. It will further strengthen Hong Kong's unique role in connecting mainland and offshore markets, he added.

According to data from the Hong Kong Stock Exchange, foreign investors held 4.1 trillion worth of onshore bonds at the end of 2021, or just 3.1 percent of outstanding yuan-denominated bonds.

The deepening financial connection between Beijing and Hong Kong through the repo market suggests that China could signal its domestic interest rate policies with greater impact to investors in Hong Kong and elsewhere.

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Since the central bank has a tight grip on monetary conditions and interest rates at home, there is a loose connection between liquidity demand and supply on the one hand and policy or key interest rates on the other.

“The two markets used to be driven by different factors,” said Lillian Tao, head of China macro and global emerging market sales at Deutsche Bank. With greater access to the repo market, “they will have more common driving factors, with onshore repo liquidity being a very large part of that.”

If offshore investors become heavily dependent on the local repo market, China's monetary policy will reach offshore markets more effectively, she added. For example, if the central bank lowers interest rates or reserve requirements, “these liquidity signals will be received by the offshore market more strongly than before.”

Expanding offshore investors' access to the onshore repo market is transformative as it opens up a range of funding and liquidity management solutions for offshore investors, lawyers including Andrew Fei of King & Wood Mallesons said in a report last month.

“We expect relevant financial market infrastructure organizations and self-regulatory organizations to formulate detailed implementing regulations in due course,” they added.