China’s Onshore Bond Market Opens Up

China’s $7.4 trillion onshore bond market, the third-largest in the world, is opening to foreign institutional investors in the latest step by China to integrate its capital markets into the global financial system.

“China’s dismantling of bond market quotas is very good news, because fixed-income investors now have a safer and better-yielding alternative to the bubble markets in developed countries,” says Jan Dehn, head of research at Ashmore Investment Management in London.

Foreign investors will be able to trade in the highly liquid interbank market, not just in the illiquid exchange-traded market, Dehn writes in a recent report. “Due to China’s enormous importance to all aspects of global economic activity, and the renminbi’s inclusion in the SDR [special drawing rights basket of currencies], we believe China’s local currency bonds will soon feature in multiple indices,” Dehn says.

Institutions with long investment horizons should bear in mind that China’s economy and its markets will be four times larger than those of the US in 25 years, according to Ashmore. China still has one of the fastest economic growth rates in the world, with very low levels of central government debt and huge external reserves, Dehn says.

China needs to free its interest rates and develop its bond markets to have an effective tool to control consumption, he says. “In effect, China will become more like the US economy,” Dehn says. “The People’s Bank of China, just like the Federal Reserve, will control consumption by changing policy rates, and the fixed-income markets will transmit these changes in monetary policy to the wider economy.”

The opening of the onshore bond market will help to offset China’s capital outflows, but analysts do not expect a sudden shift from the offshore renminbi bond market to the onshore market, in part because of yield differentials. The offshore remninbi bond market currently offers much higher yields, and investors likely will wait for the yield gap to narrow.