(Bloomberg) -- China’s gradual approach to opening its bond market led some foreign investors to start viewing Chinese bonds as more akin to debt from developed nations rather than emerging markets, but the continuation of that reputation depends on how Beijing handles this year’s record sell-off by foreigners.
That’s according to the economists behind a new research paper “Internationalizing Like China,” published this month by the National Bureau of Economic Research in the US. The authors carried out a detailed analysis of the foreign ownership of Chinese bonds, which reached nearly $640 billion at the start of 2022.
“We were interested in whether the private market was buying these bonds as part of emerging market portfolios or developed market safer debt,” said Matteo Maggiori, one of the study’s authors who is a professor at Stanford University. “Interestingly it turned out to be in the middle.”
Chinese bonds hold a reputation somewhere in between the two most developed emerging markets, Israel and South Korea, the paper finds. By some measures, whether a fund holds Chinese bonds is more closely correlated with whether it also holds developed market bonds, the authors add.
“China’s portfolio correlation with developed markets has increased, consistent with an improving reputation,” the paper argues. “The dynamics of reputation make Chinese debt a substitute for emerging market risky debt in the early stages of internationalization and more of a substitute for developed market safe debt in the later stages,” it adds.
China’s bond market, which began opening gradually to foreign investors about two decades ago, has experienced record outflows so far this year due to rising global interest rates, worries about Beijing’s ties with Moscow, and China’s slowing economy.
“The recent outflows are the kind of market test that the paper is about,” said Maggiori. “If China doesn’t tamper with the outflows and the market infrastructure holds up well, then this might ultimately increase the reputation of China’s domestic bond market in the eyes of foreign investors.”
Read more: China’s Policy Easing Risks Upending Tentative Return of Inflows
Maggiori noted that Beijing hasn’t banned outflows and has opened foreign investors’ access further this year by allowing foreign capital into its secondary bond market. “So far, it seems reforms on opening up the bond market might continue,” he said.
China first opened its bond market to foreign governments and central banks, with substantial purchases by overseas private funds starting in 2019. That initial opening was governed by strict quotas and narrow restrictions on who could invest, allowing it to take a more relaxed attitude to outflows, the paper argues.
That was true during a previous outflow episode in 2015 when authorities didn’t restrict foreign bondholders from exiting.
“Imagine what would have happened now if foreigners accounted for 30% rather than the actual 3%-4% of the domestic bond market for China,” Maggiori said. “The price pressure and stress on the system would have been much more severe. That is one major reason to progressively liberalize the market, approaching the flightier investors last.”
The largest private foreign holders of renminbi-denominated bonds are the euro area, the United States, Singapore, Japan, and Taiwan, the paper finds. Foreign investors mostly buy government or government-backed bonds.
The paper also argues that while China’s financial opening has boosted the yuan’s international status, a multi-polar monetary order is unlikely to emerge from the current dollar-dominated one. “Incumbents like the U.S. can discourage new challengers by expanding the amount of safe debt they provide to the rest of the world,” it concludes.