As China's inflation fight accelerates, the absence of a large and developed bond market leaves Beijing without an important tool to cool the economy
(Bloomberg) — Jim O'Neill is on the lookout for the great Chinese revaluation of 2010, and he's not alone.
"Something's brewing," Goldman Sachs Group Inc.'s London- based chief economist told Bloomberg News. "It could happen anytime."
China's first major increase in the value of the yuan in almost five years would cool price pressures in an economy some think will grow more than 11 percent this year. Overheating risks abound and efforts to restrain credit growth aren't working.
As this inflation fight accelerates, China is finding that it could use its own Bill Gross.
China will soon be the second-biggest economy, yet its lack of a large and developed bond market is a big liability. As Beijing tries to tighten credit, it's doing so without a primetime infrastructure of investors and dealers to help transmit policy moves to the broader economy.
That's where the absence of Gross, who runs the world's biggest bond fund at Pacific Investment Management Co., and his ilk hurts the most. When China's central bank raises interest rates, the lack of a sophisticated secondary market dampens the effect. In a sense, the People's Bank of China lacks the people to influence monetary conditions.
Federal Reserve Chairman Ben S. Bernanke altering rates in Washington means little unless bond dealers in New York, London and Tokyo act accordingly in the secondary market. It's that multiplier effect that makes monetary policy so powerful, and China doesn't have it.
Granted, China has made progress. In April 2008 the government made it easier for companies to sell debt maturing in three to five years. It reduced an over-reliance on bank loans, cutting risks in the financial system. To strategists like Frances Cheung of Standard Chartered Plc in Hong Kong, the step was a "milestone." Corporate-debt issuance has increased steadily.
The government is working to create a yield curve, even issuing debt at times when it's not pressed for cash to support the market. Bond sales could rise to 9 trillion yuan ($1.3 trillion) this year, from 4.9 trillion yuan in 2009.
Auctions conform to international standards. And on Jan. 6 the central bank reaffirmed that it will allow foreign financial institutions to sell bonds in the domestic market, while it encouraged domestic companies to sell yuan-denominated bonds in Hong Kong.
Hamstrung Central Bank
The internationalization of China's capital markets got a boost last month. The government approved stock index futures, margin trading and short selling. Good stuff all around.
Yet China's central bank remains hamstrung by the depth of the secondary market. A more liquid market would be a vital shock-absorber in times of crisis and offer investors clues about China's outlook.
Now that vast amounts of capital can be moved across the world with just a keystroke, functioning bond markets are more important than ever. So is having a group of influential, globally known bond buyers who can help remind the government its policies are wrong, either by dumping its debt or speaking out.
If traders felt, for example, that China's stimulus efforts were too aggressive and inflation loomed, they could push yields higher. Or if they sensed deflation was afoot, they might buy debt. Either way, market rates would offer vital information for government officials and investors.
The trouble is, China's financial system is still more about transferring funds from one part of the economy to another rather than the pricing of risk, said Marshall Mays, director of Emerging Alpha Asset Management Ltd. in Hong Kong.
"As such, the levels of interest have never mattered that much," he said.
That's fine for Indonesia or the Philippines, less so for an economy as important as China's. When it comes to the bond market, we can no longer give China a pass because of its status as a developing country.
Financial strength in 2010 involves more than having $2.4 trillion of currency reserves. It comes from being able to borrow in the yuan and allow foreign companies to sell locally- denominated debt. Only then will China be able to let the yuan trade freely and take a crack at replacing the dollar as the reserve currency.
Taming Hot Money
A stronger currency might take the pressure off China as it raises its bond-market game. Not only would it clamp down on inflation, but it would reduce frantic speculation in markets.
Bets on such a move are manifesting themselves in increased hot-money inflows that are wreaking havoc with the money supply. China could reverse the dynamic by announcing a revaluation with language that makes it clear it won't act again for a while.
China needs a multifaceted approach to slowing the economy and deflating asset bubbles. Administrative decrees to reduce credit creation aren't enough in the long run. Building a bond market with a cadre of Gross-like players in the game is more important.
(William Pesek is a Bloomberg News columnist. The opinions expressed are his own.)