China’s Bond Market Reaches a Tipping Point

(Bloomberg Opinion) -- For those who watch China closely, there has never been a more pivotal moment in the evolution of its economy and financial markets. More than 40 years since the start of its “Reform and Opening Up” process, and despite the volatility in U.S.-China relations, China’s commitment to market reform remains. This year will likely see the improvement of market access and the rise of new investment opportunities.

The progress with these reforms in China’s $13 trillion bond market is the latest cause for market optimism. Now the third largest in the world, it remains relatively unexplored by global investors. Times, of course, are changing. Once solely the domain of domestic investors, later joined by central banks and sovereign wealth funds, the market is now encouraging a new wave of international investors. China’s broad and diversified bond market is an opportunity they can no longer ignore.

China is acting on the four key aspects that will make it an investible bond market: market regulation, market access, investor demand and improved benchmarks. Considering the progress made, this month Bloomberg will begin adding Chinese yuan-dominated government and policy bank securities into the Bloomberg Barclays Global Aggregate Index. The phased transition will take place over a 20-month period. Once completed, Chinese bonds will be the fourth largest currency component in the index, after the U.S. dollar, the euro and the Japanese yen. Global banks predict that China may see hundreds of billions’ worth of inflows to its debt market in 2019 after the inclusion.

This decision, the most significant development to the global index since the inclusion of the euro, is a vote of confidence in the progress being made in China’s financial markets. Participant restrictions have been eased, quota limits removed, and guidelines issued governing panda bonds (foreign issuance of yuan debt). Market participants have been encouraged by the steady regulatory progress seen in the Chinese bond market. New regulations have provided global investors with the fundamental rules of engagement, and set the foundation for enhanced market access and participation through CIBM Direct and Bond Connect.

These factors have already increased the number and diversity of foreign investors in the market, with foreign holdings of Chinese bonds having grown by 51 percent in 2018 to 1.71 trillion yuan ($250 billion). There is, however, still a long way to go. Foreign ownership of China’s bond market, at about 2 percent, is low compared with about 30 percent for U.S. bonds and two-thirds for Australian bonds.

For all the positive developments in the Chinese bond market, some international investors remain apprehensive about credit risk, liquidity and operational issues, such as trading hours, taxation and language.

Credit reform in China, for instance, is essential in the eyes of offshore investors. An AAA-rated issuer in China’s onshore market may be ranked in the range between A and BBB+ in the overseas market — the rating is assigned according to criteria that differ from global standards. This makes assessments of credit worthiness and risk much more difficult for global investors, who are concerned that local ratings may not fully reflect the bonds’ risks. In an ideal world, China would simply adopt the international standards, but in reality to do so hastily would create enormous volatility. To bring the market in line with international standards, reforms will need to be made steadily.

China is taking steps in the right direction. In January, Chinese regulators gave S&P Global Ratings approval to operate a credit rating business, allowing it to provide bond rating services in China’s interbank market. This indicates regulators recognize the challenges and are engaging with the market to find solutions, with a number of tools under consideration.

Market transparency is another area that international investors would like to see addressed further. A well-functioning bond market thrives on transparency, enabling investors to make sound assessments and drive more efficient capital allocation. Keeping up the momentum and consistency of transparency efforts will attract more global investors and unlock new financing opportunities for the Chinese market. In the months ahead, it is imperative for regulators to maintain the progress toward greater transparency and avoid policy uncertainty.

Although the main barriers for offshore participation in China’s bond market are being addressed, the most important agent of change will be growing investor participation. Changes in regulations and competitive yields have sparked the first wave of global investors into the Chinese market. However, broader participation will ultimately bring about the greater market efficiency desired. A tipping point in China’s bond market is before us if global investors take hold — with patience, diligence and continued reform.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Mary Schapiro is former chair of the U.S. Securities and Exchange Commission and currently Bloomberg’s vice chair for global public policy and special adviser to the founder and chairman, Mike Bloomberg.

©2019 Bloomberg L.P.