Foreign institutions have increased their holdings of domestic yuan-denominated bonds for 10 consecutive months, rising by 66.3 billion yuan ($10.49 billion) to 4.07 trillion yuan in late January, China's Bond Connect program showed. Among them, foreign institutions' bonds under custody with China Central Depository & Clearing increased by 50.1 billion yuan to 3.73 trillion yuan in September, rising for 38 consecutive months.
The economic situation has become more complex and changeable, and the country is facing multiple pressures amid high inflation and strong expectations for further monetary policy tightening overseas. However, international investors are fully confident in China's long-term economic prospects, choosing to continue increasing their holdings of yuan-denominated assets.
For the whole of 2022, the gap between the GDP growth rates in China and the United States may hit a new low since the 1990s. China's 2022 economic growth will start high and end low, while US economic growth may slow down quarter by quarter in 2022. Compared with the gradually weakening effect of the US stimulus policy, there will be many positive factors that will boost China's economic growth in 2022.
To some extent, the narrowing spread between 10-year Chinese and US government bond yields will impact foreign capital inflows into China. High inflation and tightening monetary policy in Europe and the US will push up yields on bonds, while Chinese government bond yields may easily dip and barely rise with easing monetary policy.
As of Feb 15, the yield spread between Chinese and US 10-year Treasurys shrank 51 basis points from the end of last year to 74.5 BP, lower than the "comfort zone "spread of between 80 and 100 BP.
However, the narrowing spread is to be expected. Affected by this, the net increase in foreign holdings of domestic yuan-denominated bonds fell by 5 percent month-on-month in January. On a yearly basis, the net increase decreased by 70 percent in January. Even so, foreign investors rarely reduce their holdings of domestic bonds, as yuan-denominated bonds may still be "under-allocated" in the asset allocations of foreign investors.
Data from China Central Depository & Clearing showed bonds held by foreign institutions under custody only account for 4.24 percent of total bonds under custody, lower than the 30 percent in the US. In addition, the structure of yuan-denominated bonds held by foreign investors is relatively simple, as government bonds and bonds issued by financial policy institutions account for 68 percent and 29 percent of bonds held by foreign investors, respectively.
There are many overseas risks foreseeable this year, including the COVID-19 pandemic, inflation risks (energy crisis, food crisis and supply chain disruptions), and expected US Fed policy tightening. On the contrary, domestic policies and economic situations point to stability, which is attractive to foreign investors looking to reduce volatility for asset allocation.
Investors at home and abroad said yuan-denominated assets are useful to hedge risks.
In overseas markets, high inflation and Fed policy tightening may trigger further selling of US Treasurys, and the rising yields will undoubtedly put pressure on equity market valuations. Domestically, the People's Bank of China's moves such as required reserve ratio reductions showcased that they have become a necessity to stabilize growth.
The International Monetary Fund has repeatedly warned that emerging markets should be wary of foreign investors pulling money out of those markets amid Fed policy tightening, and China will also be affected. However, the IMF also said China is the ballast stone of emerging markets. And China's relatively strong currency has further boosted foreign investors' motivations to stay.
Early in 2019, China became the world's second-largest bond market after the US. In January, the average daily trading transaction volume of the interbank market reached 5.3 trillion yuan, exceeding the amount held by foreign investors.
In recent years, China has continuously promoted two-way opening-up of the financial market. According to the 14th Five-Year Plan (2021-25), China will comprehensively improve the level of opening-up to the outside world and promote liberalization and facilitation of trade and investment.
In February 2020, US-based financial group JPMorgan Chase & Co included Chinese government bonds in its benchmark emerging-market indexes. In November 2020, Chinese government bonds and policy bank bonds were fully included in the Bloomberg Barclays Global Aggregate Index. In October 2021, Chinese government bonds were included in the FTSE World Government Bond Index. In just two years, Chinese government bonds have been included in the three major global bond indexes, further enhancing the appeal of yuan-denominated bond assets.
Currently, developed countries, excluding Japan, are making tighter monetary policy moves. Even the European Central Bank recently changed its tune to warn of high inflation. This will have an adverse effect on the levels of emerging economies' currencies.
IMF studies have found negative correlations between the Fed's broad dollar index and capital flows to emerging economies. Capital flows to emerging economies weakened when the US dollar appreciated relative to other major currencies in 2021.
In addition, as the 10-year US Treasury yield still has room to move up and the anticipated tightening monetary policy may cause turmoil in international financial markets, most emerging economies are having a difficult time.
When it comes to China-US yield spreads, domestic investors are still the main force to determine the yields, with a key factor also being decisions made by the People's Bank of China, the country's central bank. While foreign investors pay more attention to global asset allocation, Fed moves and US Treasury yields, they have a relatively limited impact on yuan-denominated bond yields.
At the same time, the above logic may vary as investor consensus changes. For instance, divergent policies between China and the US and trade frictions between the two countries led to the continuous depreciation of the yuan and narrowing spread between Chinese and US government bond yields in 2018, while China saw a net inflow of foreign investment despite headwinds in 2018.
China has a solid foundation to keep a stable renminbi exchange rate. China has a relatively large current account surplus and a relatively low external debt, especially in foreign currencies. And it is able to cope with exchange rate fluctuations affected by the tightening of global dollar financing conditions. And a stable exchange rate environment will help reduce the exchange rate risk cost for foreign investment in yuan-denominated bonds.
The writer is global chief economist of BOC International (China) Co Ltd.
The views don't necessarily reflect those of China Daily.