China opened itself to foreign investors on Monday by liberalising rules that regulate participation in its massive bond market. The new Bond Connect scheme, which was keenly awaited for months, allows large foreign investors such as banks and pension funds to buy and sell mainland Chinese bonds through offshore accounts in Hong Kong. China’s bond market, the third largest in the world, is estimated to be over $9 trillion in value and is expected to double in size over the next five years. Yet foreign investors own less than 2% of the overall bond market, thanks to China’s policy of raising significant barriers to the free entry and exit of capital. Further, its central bank, the People’s Bank of China, of late has been tightening monetary policy to squeeze out liquidity, which has, in turn, led bond yields in China to be higher than in many developed economies. So it was no surprise that investors rushed in to make use of the scheme to trade in Chinese bonds and later announced their entry. It is noteworthy that the present move to liberalise bond investment comes after the Chinese authorities took significant steps to ease the purchase of mainland stocks by foreign investors. The Shanghai and Shenzhen stock exchanges were connected to the Hong Kong stock exchange in 2014 and 2016, respectively, which allowed the entry of hundreds of Chinese stocks into international indices such as the MSCI. Chinese bonds can now expect similar international recognition.
Bond Connect is a significant step in China’s march towards a more open capital account. First, the inflow of foreign capital will help Beijing control the yuan. In time, the scheme will boost the borrowing potential of the Chinese sovereign as well as of corporations, while improving bond market liquidity by offering access to a wider pool of international capital. The entry of more private capital into the Chinese economy can encourage investments in economic projects as well. Also, after the inclusion of the yuan in the International Monetary Fund’s basket of currencies in 2016, the present bond reform gives a further boost to the Chinese currency. In the long run, greater participation of foreign investors in Chinese financial assets will increase the usage of the yuan, and thus aid Beijing’s efforts to internationalise the currency. This trend will also help bring more stability to China’s financial markets, known for their high levels of volatility, by improving transparency and the quality of business practices. It is worth noting that currently about 70% of bonds in China have a maturity period of less than five years, and a quarter of less than one year, as investors are wary of the risks involved in lending money over longer periods. Going forward, the challenge for Chinese authorities lies in allowing free price discovery, which can lead to painful turmoil in the short run in its bond market. It will indeed be a test of whether they have learned the right lessons from the stock market crash of 2015.
