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China’s bond market dynamics need a rethink

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By Addison Gong
20 May 2021

Foreign ownership of Chinese domestic bonds has hit an all-time high of over Rmb3.6tr ($562bn) — an impressive number but one that warrants a much closer look.

International investors have been on a buying spree of onshore Chinese bonds in recent years. Just four years ago, they held some Rmb840bn of domestic bonds. That number has now surpassed Rmb3.6tr.

There have been many drivers. The positive long-term outlook of the Chinese economy and the renminbi, the attractive yields on onshore bonds, and the low correlation between the markets in China and elsewhere have been at the core of the increased foreign interest. The inclusion of Chinese government bonds (CGBs) in major indices by Bloomberg-Barclays and JP Morgan, and most recently FTSE Russell, have only added to the appeal of renminbi bonds. 

International participation was also boosted by the launch of Bond Connect in June 2017, and improved access under other inbound investment schemes including the Qualified Foreign Institutional Investor (QFII) and its renminbi-denominated counterpart RQFII — now consolidated into one — as well as numerous other measures and incentives from Beijing to encourage foreign inflow.

So much so that, there was Rmb1tr of net foreign inflow into the domestic bond market last year, according to the People’s Bank of China.

Naturally, when non-Chinese investors reduced their holding of onshore bonds for the first time in over a year in March, it did not go unnoticed even if the sale was of a small amount of Rmb9bn, according to combined data from the China Central Depository & Clearing and the Shanghai Clearing House. In comparison the previous month, they had increased their holdings by Rmb90bn. The drop in March came as US Treasury yields climbed, making Chinese bonds — such as CGBs — less attractive for investors in terms of the spread pick-up.

But international investors’ retraction proved to be short lived. They reverted to net buying in April, adding Rmb58.1bn. The total amount of RMB bonds held, worth Rmb3.62tr, hit an all-time high.

The numbers are certainly encouraging, but they belie a worrying trend. Of the new bond purchases in April, Rmb51.7bn went to CGBs and Rmb6.2bn to bonds issued by policy banks.

This has once again revealed a trend that needs to be urgently addressed: that international bondholders are only interested in safer government-linked bonds, and are shunning China’s onshore credit bond market. 

By April, foreign participation made up 3.4% of the total size of the interbank market. That percentage drops to just about 1% for credit bonds — bonds issued by corporations and financial institutions.

While it is impressive to see continued inflow into China’s onshore bond market, this will likely miss the mark unless the country’s credit bond market — in particular corporate bonds — is fundamentally improved.

Unless foreign investors are more comfortable in increasing their exposure to China’s corporate debt, their participation in the market will remain a rates play, and the numbers will never truly reflect their interest.

Some of this will come with time, including international investors’ familiarity with the onshore market, its regulations and the various players involved.

But the many other problems that have hampered the development and further opening up of the market — such as limited transparency, lack of trust in the domestic ratings system and poor secondary market liquidity — will require much larger efforts. For this, policymakers and financial regulators will need to join hands with everyone from bond underwriters and investors to service providers like credit rating agencies, law firms and accounting firms.

Beijing has done some great work in recent years to address some of these concerns. They have built up information disclosure requirements, reformed the credit rating industry, and opened up the financial services sector to more foreign firms in a bid to bring domestic practices more in line with international standards.

But as China’s bond market becomes the second largest globally, the task now is bigger — to transform it from being just a rates story for investors to a credit story. Only then will the market see its next phase of growth. 

By Addison Gong
20 May 2021