China Bond Market Opening Paves Way to Unleash Funds on World

(Bloomberg) — In 2017, China’s launch of a debt-trading link to the rest of the world started with a whimper. Four years later, global investors are clamoring to get their hands on the country’s bonds and Beijing is opening the door wider for its traders to return the favor.

Thanks in part to attractive yields and low correlations to other markets, global funds have nearly tripled their holdings of Chinese sovereign debt to more than 10% just a few years after the Bond Connect program began with tepid interest. Its success bodes well for the expected launch of a southbound link, which will allow Chinese investors to purchase offshore bonds.

The game-changing shift as China won entry into all major bond indices put its markets firmly on the global investment map, with its assets deemed as a viable option for funds worldwide. Beijing’s initial fears of hot money, and their impact on market stability, have also given way to a desire for more capital outflows to balance the strength of foreign funds flowing in.

“As foreign capital inflows increase, China’s focus will be to unleash domestic demand for global assets,” said Becky Liu, head of China macro strategy at Standard Chartered Plc in Hong Kong. “The goal is to eventually enable two-way opening of China’s capital account.”

China’s steps to loosen capital controls come at a time when the nation’s government bonds have taken on broader popularity in a world starved of attractive debt. Substantial yield premiums over developed-market peers and insulation from global trends have made Chinese bonds more coveted than ever.

Out of $18.9 billion inflows into emerging-market debt last month, more than a quarter went into Chinese bonds, according to data from the Institute of International Finance. The benchmark 10-year Chinese bond yielded 3.1% Friday, compared to just 0.8% for a gauge of global peers.

“China has slowly become one of our core holdings,” said JPMorgan Asset Management’s Arjun Vij, whose $1.3 billion Global Bond Fund is around 9% invested in Chinese debt from no exposure at all four years ago to yuan-denominated bonds. “It’s hard to say never but it’s unlikely we’ll be at zero again.”

Foreign inflows were enough to help fuel a rapid rally in the yuan in May to its highest against the dollar since 2018, raising concerns that speculative flows could reverse suddenly later in the year, unsettling Chinese markets.

That prompted the People’s Bank of China to take steps to slow the pace of gains and authorities also increased the quota for another program which allows domestic investors to purchase overseas assets to a record $147 billion.

Room for Improvement

Still, even as China’s opening of its bond market — the world’s second largest — has received acclaim, aspects of trading could still be improved. Foreign funds have been vocal about their desire for better ways to manage risk such as access to onshore futures.

“In China, the risk part of it is still difficult to quantify because we still don’t have a tool to do that,” said Paul Sandhu, head of multi-asset quant solutions Asia Pacific at BNP Paribas Asset Management. “Having derivatives and a robust derivative market will help us quantify the risk and that will make investors like myself put higher allocations into China.”

Most Asian bond markets still have higher percentages of foreign holdings compared with China. Overseas institutions own over 20% of Indonesian and Malaysian sovereign debt, according to data from the Asian Development Bank. Government bond markets in Japan, Korea and Thailand have foreign holdings of around 13% to 14%.

Liquidity could be better, said JPMorgan’s Vij. The average weekly turnover of $715 billion in Chinese bonds last month is less than a quarter that of U.S. Treasuries.

Investors also have to navigate China’s capital and currency controls, making purchases or fund withdrawals harder.

Like the initial northbound bond link, the upcoming southbound channel will likely integrate Chinese investors into the international financial system in incremental steps.

While official details haven’t yet been announced, domestic traders are likely to gain access to different types of dollar notes, offshore yuan debt and other foreign-currency bonds that are accessible in Hong Kong, although they could have a quota for purchases.

This will still allow them to diversify their portfolios while banks will have someplace new to park surplus holdings of U.S. dollars, which have been a growing concern for authorities due to the potential pressure on the yuan.

“China has been pacing its capital liberalization according to external environments,” said Wei Yao, chief economist for the Asia Pacific at Societe Generale SA. “Faster relaxation on outflow channels since late last year makes good sense against the backdrop of yuan strength and strong inflow pressures.”

Contact editor Michael Bellart (michaelbellart@caixin.com)

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