China, the world's third-largest bond market accounting for $9 trillion in debt instruments, has started the process of opening up to foreign investors. Two major investment banks, including Citigroup, have announced plans to join the fray and several others are expectantly watching the unfolding situation.
It's not a sudden desire to liberalize, but pressure from shrinking foreign capital inflows and expanding outflows that has motivated Beijing's communist leaders into this new and uncertain path.
“China's purpose is to attract capital inflows from investors needing RMB [Chinese yuan] assets for their portfolio,” said Jacob Kirkegaard, economist with the Peterson Institute of International Affairs. “This will also help to stabilize RMB exchange rate."
FILE - The HSBC headquarters is lit up at the Central Financial District in Hong Kong, Nov. 3, 2015.
China has suffered some serious loss of capital because of uncontrolled outflows and a recent decline in its foreign direct investments, which saw a drop of 9.2 percent in January. The country also suffered its first trade deficit in three years last month.
To overcome the situation, Beijing recently allowed overseas investors to hedge their currency risks at the local derivative market. This partially opened the doors to foreign players who saw currency risk as a major deterrent in the Chinese bond market.
Chinese Premier Li Keqiang threw in a sweetener in mid-February, saying the government would launch a trial program to connect the bond market in mainland China with Hong Kong, which is the base of operations for a large number of foreign investors. The bond connect will make it easier for Hong Kong-based investors to access domestic Chinese instruments without leaving the city.
"I see that as a part of China of becoming a major player and becoming an important destination for financial investors, " Lourdes Casanova, Director of Emerging Markets Institute at Cornell University's SC Johnson School of Management, said.
This move is also meant to promote the use of RMB as an international currency.
“These efforts indicate that China wants to assert its economic, business and financial power with all the inherent advantages and risks,” Casanova said.
The past few weeks have seen Bloomberg Barclays become the first major index provider to include Chinese yuan bonds in its global offerings. Citigroup has announced plans to embed China bonds into its bond market benchmark WGBI-Extended. JPMorgan Chase & Co., another index maker, said it is evaluating the entry of China markets into its JPMorgan Global Emerging Market Bond Index.
FILE - Euro, Hong Kong dollar, U.S. dollar, Japanese yen, British pound and Chinese 100-yuan banknotes are seen in a picture illustration shot, Jan. 21, 2016.
This is not surprising because the RMB, or the Chinese yuan, is now part of the International Monetary Fund's coveted special drawing-rights basket.
“There are global investors who wish to shadow the IMF SDR basket, and needs RMB exposure,” Kirkegaard said.
At present, foreign investments account for just about $120 billion, or 1.33 percent, of China's bond market. But the situation is expected to change soon as investment banks and index makers have started the process of measuring steps before entering the market in a big way.
Given China's role as the second-biggest economy, it is natural for Chinese investors to want Chinese bonds in their portfolio, Casanova said. In fact, foreign investors face fewer challenges in China's bond market compared to what they are up to in other emerging markets, she said.
"Yes, there are many doubts, there are many doubts in many countries. I am European, I am from Spain, there are doubts about the viability of the euro. In the U.S. there are other types of worries,” she said adding, “That's why also for the international investors, China is not as risky as it used to be."
Casanova said, “The risk of default is minimal given the amount of Chinese reserves and the risk related to currency swings are also much less than, let’s say, Argentina, which has been issuing debt recently."
Doubts and challenges
But foreign investors will have to tread carefully because it is not easy to seriously analyze credit risk in China where the markets are not transparent and there is not much information available about issuers and major buyers of debt instruments, he said.
“Their [foreign investors'] willingness to invest will be dependent on the implicit government guarantee against default... foreign investors won't be able to seriously analyze credit risk in China,” he said.
Casanova sees the situation differently. She points out there are risks in most markets across the globe, and international investors will choose what suits them best.