China's Deleveraging Puts the Yuan Closer to a Free Float

China's financial markets are fascinating to watch these days. Efforts by officials to decrease the nation’s enormous debt pile without destabilizing domestic markets are having profound consequences, most visibly in the bond market, where the yields on short-term debt have risen above those on longer maturities for the first time. The implications are more than just academic. In fact, they will likely pressure China to allow the yuan to become a free-floating currency sooner rather than later.

Market historians know that an inverted yield curve generally means tougher economic times ahead and the potential for capital flight. Presumably, China knows this as well, which is why it has embarked on a flurry of initiatives to give foreign investors broader access to the nation’s markets. China’s State Administration of Foreign Exchange allowed foreign investors to hedge onshore yuan forwards, Chinese government bond futures were launched by the Hong Kong Exchange, and China Bond Connect was established to provide mutual access between mainland and Hong Kong bond markets. And by year-end, China could be included in major bond indices, resulting in an estimated $250 billion flowing into its debt securities as global investors scoop them up to maintain pace with changes to benchmark indexes.