China is right to be cautious about opening up its bond market

The liberalisation of China’s capital account is an acutely sensitive issue for Beijing, mainly because of the Communist Party’s innate desire for control
The global policy landscape has changed sharply in the past decades, and there is plenty of evidence that free capital mobility exacerbates financial crises

Nicholas Spiro

Published: 3:30am, 16 Apr 2021

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Is China becoming a victim of its own success? The country’s deft handling of the Covid-19 pandemic, its swift and robust economic recovery, and its higher-yielding and stable government bond market have fuelled a surge in overseas holdings of its sovereign debt.

The rapid pace of inflows has made Beijing increasingly nervous about the risk of asset bubbles, especially given the vulnerability of emerging markets to this year’s sharp rise in US Treasury yields.

Last year, foreign investors bought US$155 billion of Chinese government bonds, increasing their share of the market to more than 10 per cent, up from 8.5 per cent at the end of 2019, and just 4 per cent at the start of 2017, according to data from JPMorgan. The aggressive purchases continued in the first few months of this year, with inflows into China’s bond market hitting a record high in January.

The influx of foreign capital into the world’s second-largest debt market is supported by the phased inclusion of onshore bonds in benchmark global indices, cemented by last month’s confirmation by FTSE Russell that China will enter its flagship World Government Bond Index in October.

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Index inclusion is helping integrate Chinese financial assets into international capital markets, underpinned by domestic reforms aimed at boosting liquidity and transparency. Depending on the pace and scope of these reforms, the opening up of China’s debt market could mark one of the most far-reaching changes to global markets since the launch of the euro in 1999.

However, the liberalisation of China’s capital account has long been an acutely sensitive issue for Beijing, mainly because of the Communist Party’s innate desire for control, but also because of the problems other emerging markets faced after lifting restrictions on capital flows. “Crossing the river by feeling for stones”, a saying associated with the late Deng Xiaoping, remains a guiding principle of Chinese reform.

Indeed, even after the inclusion of China in global bond indices, there are still significant technical impediments to establishing the kind of widely traded and transparent debt market that appeals to overseas investors, particularly those from Japan, which has a large weighting in international bond indices.

The tax treatment of foreign investors, insufficient liquidity – the turnover rate of Chinese government bonds is minuscule compared with that of the United States and Japan, the largest and third-largest debt markets respectively – and inadequate hedging capacity continue to restrain foreign participation in China’s debt market.

Yet, the fact that Beijing is concerned about the pace of inflows shows it is in no rush to loosen its grip on the nation’s capital markets. While China benefits from a sustained influx of foreign capital, which helps finance growth and promote the global use of the renminbi, it is more convinced than ever that caution is warranted.

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First, the global consensus on capital account liberalisation has changed markedly over the past two decades. As a paper published by the International Monetary Fund in August 2020 notes, the 1997-98 Asian financial crisis marked a turning point in the IMF’s views on the management of capital flows.

This led to the publication of an officially approved report in 2012 acknowledging that restrictions can, under certain circumstances, play a role in countering the threat posed by large and volatile capital flows.

Second, and more importantly from a sentiment standpoint, the resilience and attraction of China’s sovereign debt market stem partly from its low correlation with the bonds of advanced economies, in particular US Treasuries. This helped insulate Chinese debt from the recent sell-off in global bond markets, increasing its appeal among foreign investors.

Third, strong domestic ownership of Chinese bonds is providing technical support, in contrast to many other developing economies’ government debt markets, whose significantly higher foreign ownership ratios make them more vulnerable to shifts in global sentiment. JPMorgan notes that Chinese debt “remains a largely domestic driven market with the [People’s Bank of China’s] liquidity stance and the growth and inflation outlook being the primary drivers”.

To be sure, Chinese bonds hardly qualify as a safe haven. Liquidity and transparency need to improve significantly to boost market access and increase overseas investors’ confidence in the market.

Yet, the global policy landscape has changed sharply since the 1980s and 1990s, when capital account liberalisation was in vogue. Not only is there much less consensus today on the benefits of open capital accounts, there is plenty of evidence that free capital mobility exacerbates financial crises.

While Beijing is instinctively wary of losing control of its policy levers, the post-pandemic volatility in markets makes the challenge of managing capital flows particularly acute. Policymakers’ fears that the surge in inflows could quickly turn into outflows have been heightened by the recent weakness of the yuan against the dollar and the narrowing yield gap between US and Chinese bonds.

Last month, foreign investors reduced their holdings of onshore debt.

The scope for further inflows into China’s bond market, which is just beginning to open up, is huge. However, Beijing is right to make sure it does not lose its footing while crossing the river.

Nicholas Spiro is a partner at Lauressa Advisory

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