Despite signs of the People’s Bank of China (PBoC) slowing down the process of capital account liberalisation (as I argued in “Short-term Policy Tactics May Have Changed”, 24 February 2016), China has announced that it is opening up the onshore bond market to trading and investment by foreign long-term investors without any restrictions on Qualified Foreign Institutional Investor (QFII) and Renminbi Qualified Foreign Institutional Investor (RQFII) quota holders.
Opening up areas where there is least resistance to change
The move can be seen as part of a strategy of opportunistic liberalisation – i.e. opening up areas where there is least resistance to change and whenever opportunities present themselves. It also honours China’s pledge to continue opening up its capital account as the renminbi becomes one of the IMF’s Special Drawing Rights (SDR) currencies. The news of the opening-up of the onshore interbank bond market was carefully timed to immediately precede the G20 meeting in Shanghai.
The liberalisation of the onshore interbank bond market for foreign private-sector investment can be seen a structural move to attract foreign participation in the onshore capital market. Since the new policy also applies to existing QFII and RQFII funds, Beijing appears to be trying to make foreign investment in China simpler, more flexible and, presumably, more attractive by extending the range of investable instruments to onshore bonds.
Eventual support for the renminbi
In the long run, this should help support the renminbi exchange rate and facilitate renminbi internationalisation by allowing foreign investors to buy more renminbi-denominated assets. However, given the negative market sentiment towards China and the persistent confusion over its foreign exchange policy, the short-term impact is likely to be muted.
Is China worried about more foreign players increasing volatility in the onshore market, which is a key reason for the PBoC making capital account convertibility less of a priority, as we have argued?
Probably not. Firstly, Beijing is only allowing in long-term investors such as commercial banks, pension funds, insurance companies and asset managers. Secondly, Chinese bonds are extremely under-owned by global investors. Currently, total foreign holdings of domestic Chinese bonds is about 1.7%, or USD 120 billion, of the estimated USD 7 trillion domestic bond market. Even if foreigners doubled their holdings following this policy announcement, which is unlikely in the short term, they will still be a drop in the bucket in the onshore bond market and the inflows would be small compared to the estimated USD 700 billion capital outflows recorded last year.
Thirdly, foreign private investors will only be allowed to invest in or trade cash bonds in the interbank bond market. They have no access to bond instruments such as repos, futures and forwards, interest-rate swaps and bond lending. This is still limited to official institutions such as central banks and sovereign wealth funds.
What about the recent capital-flow restrictions?
Granted, this latest measure comes on the back of steps by Beijing to restrict capital outflows. These included raising the hedging cost of renminbi forward contracts and halting the Qualified Domestic Institutional Investor 2 (or QDII 2), allowing investors to invest in foreign securities markets, and Qualified Domestic Limited Partner (or QDLP) schemes.
While these steps can be seen as back-peddling on financial liberalisation, I regard them as short-term measures to stem the outflows and to prevent potential systemic risk. In my view, they do not change the long-term move towards liberalisation; otherwise, Beijing would not have opened up the onshore bond market at this juncture.
It appears international authorities are doing their job in reminding China of the need for further progress. Moody’s recent downgrade of China’s sovereign rating outlook to negative, citing rising government debt and rising liabilities on the government balance sheet, a continuing fall in reserve buffers due to capital outflows and uncertainty about the authorities’ capacity to address imbalances in the economy, signals to Beijing that it must stay on the reform track.
Index membership in due course
From an internationalisation perspective, broadening foreign participation in the domestic bond market should pave the way for global index service providers to include Chinese bonds in global indices as and when more foreigners buy Chinese domestic bonds.
In a nutshell, the opening up of China’s domestic bond market to foreign investors is in my view a positive further move, facilitating the internationalisation of the renminbi in the long term and bringing more market discipline to the Chinese system. Ultimately, such structural changes should improve China’s growth quality. All told, though, the short-term impact on financial markets is likely to be subdued.
Exhibit 1: Outstanding bonds, RMB million
Source: Wind, ChinaBond, January 2016
 Source : CEIC, Bloomberg as of February 2016