Boosting the move into Chinese assets

The move to include the yuan will take effect Oct. 1, 2016. China is likely to let its currency and domestic bond markets take their chances in global finance, reducing the cost of central bank support.

China’s capital markets will take in new flows of foreign money, even though the immediate effect of inclusion of the yuan in SDRs will be minor in global trade, explains Liu Li-Gang, chief economist for Greater China at Australia and New Zealand Banking Group Ltd.’s research unit in Hong Kong and a visiting fellow at the Peterson Institute for International Economics in Washington, D.C., an influential think-tank. “Global trade is conducted in major currencies, not SDRs,” he notes.

The yuan will become a currency as major as the SDR’s other components, each a pillar of global fixed-income markets, Liu suggests. The yuan currently is pegged to the US$ by the daily operations of the Bank of China. The IMF move may encourage Beijing authorities to let the yuan float, adding to its importance as a major and independent currency.

“Right now, yuan-denominated bonds are just 1% of assets held by asset managers,” says Shaun Osborne, chief foreign exchange strategist at Bank of Nova Scotia in Toronto. “But the weight will grow. Eventually, the yuan bond market should rise in global markets to the weight of the yen and sterling.”

For now, the US$ comprises 41.9% of the SDR; the euro, 37.4%; the pound sterling, 11.3%; and the yen, 9.4%.Those proportions will be slightly reduced in favour of the yuan, which will have an approximately 11% weight in the SDR.

The yuan could weaken if China ends the US$ peg in order to protect its export markets in the slowing global economy. The yuan-denominated bond market will become deeper and more accessible over time as a result of currency inflows that have to be parked someplace – often in bonds.

As China’s bond market expands, the dominance of Chinese banks in financing government and business operations will diminish. Foreign investors will move in to diversify their bond portfolios, expanding the market for Chinese corporate and sovereign debt.

“The process will be slow,” says Adam Cole, director and head of G10 foreign exchange strategy with Royal Bank of Canada in London, U.K.

The opening of China’s debt market to foreigners will have substantial benefits for the country’s capital markets as a whole. The yuan will gain the attributes of other reserve currencies, Osborne explains, and also should be easier to trade.

Advantages also are clear for interest rates. At the end of November 2015 10-year Government of China bonds paid 3.98%. In comparison, 10-year Canada bonds paid 1.57%, and 10-year U.S. treasuries paid 2.27%.

The opening of China’s bond market to new players – investment funds and institutions such as insurance companies – rather than mom-and-pop savers will encourage the move of US$1 trillion into Chinese assets, according to a report from U.K.-based bank Standard Chartered PLC, a major player in Hong Kong.

South Korea stepped up soon after the IMF announcement with a registration to sell three billion yuan (US$467 million) of notes.

With the yuan not only exchangeable and convertible but also investible in yuan-denominated bonds, foreign investment (from the Chinese viewpoint) in yuan-denominated debt, known as “panda” bonds, is expected to grow, Standard Chartered’s report predicts.

Until March 2, 2015, China’s 28 trillion yuan panda debt market had been closed to overseas non-financial services companies even as 453,400 foreign enterprises with ventures in China sought to expand their businesses. The opening of China’s bond markets to foreign investors could generate as much as US$50 billion of Chinese debt, according to World Bank projections issued in October 2015. British Columbia announced in early December that it would issue panda bonds in 2016.

China-based companies, for their part, will have an enlarged bond market in which to borrow. However, the process of shifting debt from banks to bonds could take many years before it reaches Western proportions, Cole adds. The process also could be a rocky path, however, for defaults on corporate bonds have risen to six from years of none.

The additional liquidity and depth of the yuan as an exchange currency should increase the size of the panda bond market.

In comparison, sales of offshore yuan securities, the so-called “dim sum” bonds mainly traded in Hong Kong, jumped 25%, to 351 billion yuan in 2015. That level exceeded previous full-year totals in data compiled by Bloomberg LP.

Panda bonds are sure to catch up. For the bond market as a whole, issuance has risen to 12 trillion yuan (US$1.9 trillion) from 7.7 trillion yuan in all of 2014. Perhaps money has flown from sagging stocks to bonds.

Liberalization of China’s bond market will relieve pressure on that country’s banking system, which has financed most of the country’s remarkable growth for the past few decades.

Bank borrowing by the non-financial services sector in China was 240% of gross domestic product (GDP) in 2015. By comparison, the Peterson Institute reported on Nov. 3 that the ratio of corporate debt to GDP is 70% in the U.S.

Offshore (to China) investors seeking yield will take debt off the hands of China’s banks, reducing both their default exposure and their need to tie up vast amounts of capital to back loans, explains Chris Kresic, senior partner and head of fixed-income at Jarislowsky Fraser Ltd. in Toronto. He also notes that heavy rollovers of local government loans are expected in 2016.

Liberalization of China’s bond market appears to be coming at an opportune time.

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