China's bond market opens up but hurdles remain

Even with greater access to the $5.4 trillion market, foreign investors remain wary of capital controls and foreign exchange risk.

Beijing’s latest effort to expand access to its domestic bond market has largely been welcomed by foreign investors but concerns over cross-border capital flows and exchange rate risk remain.

In a statement on its website late Wednesday, the People’s Bank of China said most types of overseas financial institutions will no longer require prior approval or quotas to invest in the country's Rmb35 trillion ($5.4 trillion) interbank bond market. 

The move dovetails with China's long-term goal to integrate more fully with global financial markets by dismantling currency controls. But a more pressing motive could be to support the country’s financial system by offsetting capital outflows and lifting pressure on the renminbi, given that foreign investors currently account for less than 2% of the market, according to GaveKal Research.

Deutsche Bank forecasts that foreign ownership of renminbi-denominated bonds will rise to between 8% to 10% of the market in the next five years, potentially translating into as much as Rmb10 trillion ($1.53 trillion) worth of capital inflows.

In a world where a very large proportion of liquid bond markets outside the US have negative yields, Chinese government bonds will provide positive yield, much to the attraction of global institutional investors, British fund management firm Schroders added.

The flipside is that the market is now also better positioned to begin drawing foreign companies with business interests in China that might want to raise debt finance denominated in renminbi.

“What is particularly attractive is the continued opening up for foreigners to hedge onshore assets directly in renminbi by issuing liabilities domestically,” Keith Pogson, a senior partner at accounting firm EY, told FinanceAsia, playing up the possibilities.

“The Chinese interbank bond market has matured [into] an attractive source of funding which is more keenly priced than the loan market and accesses a deep pool of liquidity,” Pogson said.

By allowing quota-free access for foreign investors, China is effectively opening up its domestic interbank bond market to most foreign investors with the exception of hedge funds and retail investors.

Commercial banks, insurance companies, securities firms, fund management firms and other asset managers are now among the eligible applicants. Long-term institutional investors such as pension funds and endowment funds also qualify.

That follows the PBoC's decision in July to lift restrictions on foreign central banks, sovereign wealth funds, and global financial organisations to enable them to trade domestic bonds, interest-rate swaps, and repurchase agreements more easily.

In a separate but aligned development in September, HSBC and the Hong Kong unit of Bank of China became the first foreign commercial banks to issue bonds in China. The bond sales were largely symbolic as the two lenders raised just Rmb1 billion ($157 million) each but underscored Beijing’s ambition to promote the renminbi ahead of the International Monetary Fund's decision in November to add the renminbi to its benchmark currency basket. 

Also, in December South Korea sold Rmb3 billion in three-year notes, making it the first sovereign issuer to sell so-called panda bonds -- renminbi-denominated debt issued in China by foreign entities.


For all this, bringing global bond investors and domestic Chinese bond markets together will not be a straightforward marriage.

China's on-off stock market turmoil and the erratic official interventions that has spurred in the last nine months could deter some foreign institutional investors, even if they do now have greater access.

“Foreign investors will remain uncertain how easy it will be to sell holdings and repatriate the proceeds,” said Chen Long, an analyst at GaveKal, a Hong Kong-based independent research. “Beijing’s reputation for market management suffered badly during last year’s stock market bailout... And if they are not sure they will be able to sell in the future, they will not buy today.”

One Hong Kong-based hedge fund manager added that the credit rating standards of global investment professionals differed from those in China, which often failed to adequately address the underlying risks.

“In contrast to [the] international market, the heavily indebted property developers are rated high-grade bonds in China because of policy relaxation rather than an improvement in their financial conditions,” said the fund manager, who requested anonymity.

Plus, although Chinese government bonds offer attractive yields compared with developed markets, the question is whether the added premium provides sufficient compensation for the extra exchange rate risk.

The value of the renminbi against the US dollar has dropped about 5% since August, when the central bank unexpectedly devalued the currency, fuelling fears of global currency war.

"Given the market's concerns over renminbi exchange rate risk, the lack of liquid tradable tools to hedge renminbi exchange rate/interest rate risks may discourage foreign interests in the near term," Linan Liu, a strategist at Deutsche Bank, said in a note.

But further ahead there is the promise of Chinese bonds entering the global investment mainstream by being added to benchmarks commonly tracked by institutional investors.

"We believe that as operation details are spelled out, bond index providers could start including Chinese onshore bonds in global indices. This would also attract global investor interest," Schroders said.

* FinanceAsia's 7th Annual Borrowers and Investors Forum takes place in Hong Kong next week. For registration and more details click here

This article has been corrected to show Deutsche Bank forecast that foreign ownership of renminbi-denominated bonds will rise to between 8% to 10% of the market in the next five years (not a 10% rise). 

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