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Why onshore renminbi must be allowed to support Stock Connect before MSCI inclusion
The prospect of a shortage of CNH liquidity has raised concerns among investors, brokers and custodians
Bayani S Cruz 11 Jan 2018

THE forthcoming inclusion of 222 A-share stocks in the MSCI Emerging Markets index in May, is expected to create liquidity problems for users of the Stock Connect unless they are allowed to use onshore renminbi, also known as CNY, for financing their trades, in addition to offshore renminbi, known as CNH.

The prospect of a shortage of CNH liquidity has raised concerns among investors, brokers and custodians who, together with the Hong Kong Monetary Authority (HKMA), are currently rushing to work out solutions that will allow users of the Stock Connect to tap CNY as well as CNH for liquidity in financing their Stock Connect transactions.

The concerns have become more serious following the implementation of real-time delivery versus payment (DVP) last November 20. Real-time DVP essentially requires payment upon delivery of the shares and effectively eliminated the four-hour time gap between the delivery of stocks and the receipt of payment that existed prior to its implementation.

As the date for the MSCI inclusion draws closer, trading volumes are expected to increase on the Stock Connect as fund managers rebalance their portfolios to match the asset allocation of the MSCI EM index. Essentially this means that the fund managers have to raise their allocation to China A-shares by 5% on or before May.

The issue is whether there will be enough CNH in the market to finance the expected increase in trading volume particularly during the “rebalancing weekend”, when the MSCI inclusion takes place officially. It remains to be seen exactly how much CNH is going to be consumed on a T+0 basis on the weekend of the MSCI rebalancing.

At present, the issue is somewhat alleviated by the fact that the trading volume is capped at 13 billion renminbi per day, the daily quota set by the Stock Connect.

“Before the MSCI inclusion, the daily quota functioned as a check on the system because at any given day all the banks (in Hong Kong) need to do is find 13 billion renminbi in net liquidity and send it to China for settlement of the trades,” says Cindy Chen, country head, Hong Kong Securities Services, Citi.

But with the MSCI inclusion and implementation of real-time DVP, the daily quota is expected to be scrapped eventually as it gives way to heavy pressure from increasing demand for A-shares and the corresponding increase in trading volumes on the Stock Connect.

“If the quota is removed and the market depends solely on CNH for financing Stock Connect trades, it remains to be seen how much CNH liquidity can be sourced on the same day basis at a reasonable price. Liquidity in the CNH market is actually decreasing because it is also used for settling trades on the Bond Connect,” Chen says.

Another issue is the difference in the settlement cycles between the CNH, which settles at T+2, and the Stock Connect, which settles at T+0.

“With real-time DVP, if you’re sourcing liquidity from CNH to finance Stock Connect transactions, the problem is you’re basically trying to draw liquidity from a market where there’s a potential scarcity of liquidity on a T+0 basis,” says Barnaby Nelson, managing director and head, securities services, transaction banking north east Asia and Greater China, Standard Chartered Bank.

Without CNY as a source of liquidity for the Stock Connect, there are a number of potential solutions that are being worked out by the HKMA and the Hong Kong Association of Banks (HKAB), the industry body for Hong Kong banks. Among these would be stockpiling CNH before the rebalancing, extending the settlement cycle of the Hong Kong Exchange from T+0 to T+1 to bring it closer to the CNH settlement cycle, and use the RQFII scheme instead of the Stock Connect for their rebalancing. However, the Stock Connect is admittedly more efficient and faster than the RQFII.

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