China surprised investors on 24 February by announcing that it will broaden foreign access to its interbank bond market, eliminating quotas for most overseas financial institutions buying local currency bonds.
The move comes one to two years sooner than expected – and amid the tumult in China’s stock market and currency. What does it mean?
In the short term, much will depend on the timing, the operational details and the amount of flexibility investors will have to move flows out of China. But from a medium-term perspective, the announcement is very significant.
First, it is clearly a major deregulation and a milestone in China’s capital account liberalization process. While the effects will take months to become visible, foreign investment is likely to materially increase. Estimated at U.S. $5 trillion‒$6 trillion, China’s bond market is the third largest in the world, but foreign investors now hold only around 2% of the market.
Chinese bonds are also likely to be included in major bond market indexes sooner than expected ‒ probably in the next year or two, by our estimate. At first glance, China’s bonds offer attractive yields: The 10-year Chinese government bond, for example, now yields around 2.90% compared with the 10-year U.S. Treasury at about 1.84%. However, once currency hedging costs are taken into account, the carry disappears. To overcome this, investors will most likely look to local corporate credit to add yield.
For China, the move helps achieve several objectives. The existing quota system for foreign investors (other than central banks and sovereign wealth funds) restricted inbound flows, while capital account outflows have been running at
U.S. $100 billion–$120 billion monthly. Over the medium term, opening the valve to inflows may help alleviate pressure on China’s foreign currency reserves and on the Chinese yuan. The short-term pressures on the currency remain, with greater scrutiny of monthly flow data by investors.
The opening of the bond market also aligns with the People’s Bank of China’s desire to see more Chinese companies finance themselves in the local corporate bond markets and rely less on banks and the shadow banking system. And it dovetails with China’s goal to see more foreign entities issue “Panda” bonds onshore in the Chinese yuan.
Inflows over the next year may be marginal compared with current monthly outflows, and the impact on bond yields will probably be modest. Over time, however, as barriers are removed and foreign investment increases, China’s bond yield curve will begin to interact with other global asset classes, a significant development for China and financial markets.
With the broader inclusion of Chinese equities in the MSCI emerging market indexes – widely expected to happen this year – we are moving rapidly from “made in China” to “trade in China.”