Wanted: World Class China Bond Market to Match SDR Currency

  • Analysts expect major growth in China's government bond market
  • But widespread reforms still needed to lure foreign investors

What if you had a reserve currency but nobody wanted -- or even could -- hold much of it?

That’s somewhat the situation for China as it prepares to join the reserve currency club next year. Compared with U.S. Treasuries, the typical asset held as reserves in dollars, buyers face a thicket of rules and a limited array of counter parties. For one thing, besides central banks and sovereign funds, not many other foreign investors can currently buy Chinese government bonds.

Officials recognize the scale of their task -- People’s Bank of China Deputy Governor Yi Gang said Dec. 1 that there was a lot of work to do on building the nation’s capital markets. Gradually letting more investors buy government bonds, establishing the market infrastructure for borrowing and lending them, and providing assurance that there would be no punishment for selling the securities short, are among the to-do list items.

One reward for having a liquid government bond market that investors round the world feel comfortable buying into would be having a stronger benchmark for the trading of other debt, like corporate bonds. That would help Premier Li Keqiang as he encourages companies to tap debt markets for more funds and wean themselves from bank loans and shadow lending.

While China would have to surrender to the markets some control over its borrowing costs, that’s the price for increasing the nation’s sway in a global financial system currently dominated by the dollar.

"It will take time, but there is no doubt that the Chinese government bond market will become a fulcrum global asset class," said Luke Spajic, portfolio manager for emerging markets at Pacific Investment Management Co. "It’s importance cannot be understated."

Reform List

But getting to that point won’t be easy. Analysts say authorities in Beijing will first need to complete a laundry list of reforms, similar to the process that won the yuan inclusion in the International Monetary Fund’s basket of reserve currencies. 

On the agenda: further opening capital borders, lifting caps on foreign investment, getting inclusion into key bond indexes, improving transparency around pricing and market making, fully opening up the market to retail and institutional investors and allowing derivative instruments to be developed.

Some changes are already underway. The Communist Party has pledged to increase the yuan’s convertibility by 2020 and to gradually dismantle capital controls. Sovereign wealth funds, central banks and approved institutional investors are being granted gradual access to the bond market.

China’s outstanding government bonds, stood at 14.6 trillion yuan ($2.25 billion) as of November, up 41.7 percent from end of last year, ChinaBond website data show

Traders say it’s difficult for most foreign investors to directly short Chinese government bonds, and that liquidity in trading China’s government bonds offshore is thin.

Long Road

"There is still a long way to go before ’Chinese Treasuries’ trade like U.S. Treasuries," said James Yip, a fund manager at Shenwan Hongyuan Asset Management (Asia) Ltd. in Hong Kong.

Overseas investors’ holdings of Chinese government and corporate bonds rose 14 percent in the first three quarters to 764.6 billion yuan, compared with a 68 percent gain in 2014. 

Foreign ownership will rise 10 percent next year to 900 billion yuan, Gu Ying, an emerging Asia currency and rates strategist at JPMorgan & Chase Co., predicted in a Dec. 9 report. That would be the weakest expansion since the onshore bond market was opened to overseas funds in 2009.

More debt is likely. The government signaled they will take further steps to support growth, including widening the fiscal deficit and stimulating the housing market, to put a floor under the economy’s slowdown. A bigger and better-functioning bond market may help underpin those policies.

"Authorities should encourage both Chinese corporates and local government to tap into the bond market for funding with ease so as to use the capital market to better facilitate the deleveraging process in the corporate and local government sectors," Australia & New Zealand Banking Group Ltd. economists led by Liu Ligang wrote in a report this week.

Ding Shuang, chief China economist at Standard Chartered Plc in Hong Kong, estimates that net issuance of general government bonds will reach around 5 trillion yuan in 2016.

Credibility Issue

Apart from reforms, there’s the issue of credibility. A wide scale government intervention into the nation’s stock markets after a $5 trillion rout this year spooked foreign investors. Measures taken included a ban on large shareholders from selling and a crackdown on short sellers -- a reminder of the role still played by the state.

"Foreign investors in the Chinese bond market should remain cautious," said Victor Shih, author of the book "Factions and Finance in China: Elite Conflict and Inflation." "The authorities will need to clearly signal to foreign creditors that their rights are equal to those of domestic creditors either by decree or through precedents."

The central government in Beijing already plays a leading role in the domestic bond market. For example, a multi-trillion yuan initiative launched by the government this year to swap high-yielding local debt into cheaper municipal bonds includes inducements for state banks to buy the new, longer-maturity, lower yielding bonds.

"The Chinese government is still very reluctant to allow the market to operate on its own," said Shih. 

Overseas issuers account for only 0.04 percent of onshore government and corporate bonds and foreign investors hold only 1.8 percent of the market, according to data compiled by Bloomberg.

Wild Card

Then there’s the wild card. China’s currency has been on a weakening trend since the IMF on Nov. 30 approved the yuan’s admission to the reserve currency club, followed by a signal this month that authorities want to loosen its managed peg to the dollar. A significant downward move in the yuan could jolt investors and drain liquidity from the market. A sudden devaluation in August sent money out of the country at a record pace.

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