MNI INTERVIEW: China Bond Inflows Seen Boosted By Yields

The inclusion of Chinese government bonds in a key index could prompt significant inflows over time, but the effect on the country's capital account should be balanced by increasing foreign portfolio investments made by Chinese financial institutions, a former senior official at the country's foreign exchange administration told MNI.

While Goldman Sachs has estimated that the move by FTSE Russell, announced on Friday, to add the nation's sovereign debt to its indices starting from October 2021 could attract $140 billion over the initial 12-month phase-in period, Guan Tao said he expected inflows to be steady but not enough to provoke volatility in bond prices.

Relatively high Chinese yields should draw foreign interest to the world's second largest bond market, said Guan, a former Director General of Balance of Payments at the State Administration of Foreign Exchange (SAFE) and now chief global economist of BOC International (China) Co Ltd, in an interview. Chinese government 10-year bonds traded at 3.125% on Monday afternoon session versus 0.659% for the equivalent U.S. Treasuries and -0.531% for German Bunds.

But inflows will increasingly be balanced by purchases of foreign securities by Chinese banks, now that the People's Bank of China has retreated from regular intervention in the foreign exchange market, he said, adding that non-banks and even non-financial corporations could also join the ranks of purchasers.

QFII QUOTAS BOOSTED

Guan's comment came after the SAFE recently expanded access to its Qualified Domestic Institutional Investor scheme permitting access to foreign markets for the first time in over two years. It increased its overall quota to USD107.3 billion, covering 157 institutions, with the additional USD3.4 billion made available to 18 institutions, including five which were new to QDII.

China's 14^th five-year plan, for the 2021-2025 period, is expected to continue the process of opening the financial system to global capital flows, and Guan said policy makers should focus on long-term stability as they hone their new framework. The country's new "dual circulation" strategy, aimed at boosting the role of the domestic economy whilst retaining export competitiveness, will mean it shifts away from its current asymmetrical stance of being more tolerant of inflows than outflows, he noted.

Changes, once made, should be permanent, as backtracking would damage investor confidence, he said, adding that rules on inflows and outflows should not just identify what types of transactions are permitted but also produce a "negative list" of those that are explicitly forbidden.

For the moment capital inflows have benefited the yuan, but Guan said it was too early to say that the currency was in a clear strengthening trend, noting that the yuan's 4% appreciation against the dollar since June had bumped into a roughly 800-pip softening since Sept. 17. While the authorities have taken a more hands-off approach to the currency in recent times, persistent strength which affects exports could prompt the People's Bank of China to step in. Investors could also be unnerved should China's trade suffer, sending the yuan lower, Guan said.

So far, the yuan has been supported by China's economy recovery, but uncertainty over a second wave of Covid-19 and geopolitical concerns could also dent its advance, he said, noting that falling returns on investment will weigh on CNY performance in the longer run.

A probable scenario is for China's currency to trade within a large range rather than to make any pronounced one-way move, Guan said. And investors are still to be convinced the yuan is a one-way bet, he continued, pointing to limited spreads between the currency's closing prices and the PBOC's daily fixing, and between the onshore and offshore spot prices.

BORROWING RISK

Another risk is that a weak dollar and low U.S. interest rates prompt Chinese companies to borrow excessively overseas, Guan said, warning that this could lead to asset bubbles and prompt excessive capital inflows. When the Federal Reserve eventually normalises policy, companies could find themselves struggling to repay dollar debt, potentially prompting a systemic crisis, he said, adding that regulators may then have to tighten macro-prudential controls on cross-border financing.

SAFE did the opposite in March, increasing its cross-border financing parameter to 1.25 from 1, giving firms more room to borrow abroad. China's outstanding foreign debt rose to USD2.13 trillion at the end of June, up 3.7% from 2019, according to the latest SAFE data.