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Investors rethink China strategy as Beijing opens up bond market

Index inclusion will accelerate global financial integration

As China's economy matures, growth has slowed, pushing the government to change its long-term strategy to focusing on improving efficiency.(Photo by Kosaku Mimura)

TOKYO -- Global investors are reconsidering their asset allocation in favor of picking up Chinese bonds after the announcement of their inclusion in a key Bloomberg index, even though the economy is slowing down amid escalating trade tensions with the U.S.

"Foreign investors were almost completely absent a decade ago," said Shaun Roache, Asia-Pacific chief economist at S&P Global Ratings in his report. Foreign investors "now hold about 2% of the bonds outstanding. This is still low by major bond market standards, but we believe we have reached an inflection point," he added.

The reason for this is because Chinese government and policy bank bonds are being added to the Bloomberg Barclays Global Aggregate Index, which is tracked by over $2 trillion of assets. The bonds will be added to the index over a 20-month period.

Once the bonds have been added completely, China's weighting in the index will jump to nearly 6%. Bloomberg said that will make China's local currency bonds the fourth largest currency component after the U.S. dollar, euro and Japanese yen.

Roache pointed out that this "would imply inflows of $150 billion" and that other index publishers, such as FTSE Russell's World Bond Index, could also be prompted to jump on the bandwagon to include Chinese bonds.

"Index inclusion will accelerate China's global financial integration with systemic implications for China and the rest of Asia-Pacific," he said.

In recent years, foreign investors have started to pour into China's financial market as Beijing slowly pried open new channels for investment and improved trading infrastructure.

According to data from credit rating agency Moody's Investors Services, the total yuan bonds held by foreign institutional investors at the end of January was $262 billion, an increase of more than 50% compared with a little over a year ago.

"Foreign investors have been increasing their allocation of bonds over the past five years. As a result, bonds carry the heaviest weighting among all RMB financial asset classes held," Moody's said in a report, referring to the renminbi, another name for the yuan.

The inclusion of Chinese bonds on a major global index will likely accelerate this trend and encourage greater foreign investment.

It will also "increase the diversity of global investors in China's bond market from foreign central banks and sovereign wealth funds that invest currently, and adding private-sector fund managers that will follow the index," said Ivan Chung, associate managing director of corporate finance at Moody's.

China's inclusion in the Bloomberg index is "another push for international investors and firms to go into China and raise funds or invest in China as a long-term strategic decision," said Charles Chang, head of Asia credit strategy and trading desk analysts at BNP Paribas in Hong Kong. He added that although it was still in the early stages, "clients have shown more interest in participating in the Chinese market."

On the other hand, China's increasingly important role within the global financial market also gives rise to new challenges and uncertainties.

With China's liberalization, "the world and international investors may need time to become familiar with its regulation and operational or investment risks and volatility that could happen," noted Tianhe Ji, China rates and foreign exchange strategist at BNP Paribas in Shanghai.

As China's economy matures, the government has been pushed to change its long-term strategy to focus on improving efficiency and productivity. "Efficient allocation of capital in China's financial markets will be key to the country's role as a growth engine, that means other emerging markets and global growth will also be affected," Chang said.

Roache warned that increasing asset flows into and out of China's bond market means that the country will be exposed to "the vagaries of the global financial cycle." This implies that China's bond market will become more vulnerable to global events and uncertainties.

"China's policymakers will have to adapt to this new reality," said Roache. S&P raised two options for policy change including a more flexible exchange rate. "Our opinion is that financial stability in China [and also the rest of the world] would be best served by letting the exchange rate act as the key capital flow shock absorber."

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