China woos with a hint of onshore hedging: Citi

Last month’s brake on foreign profit repatriation and an invitation to allow foreign institutional investors onshore FX risk hedging could significantly reduce China’s capital outflow this year, according to Citigroup's chief China economist, Liu Li-Gang.

As Premier Li Keqiang arrives in Australia to begin a tour of the national facility, Liu told AB+F that China has not suddenly tightened capital controls “merely, they have enforced the existing capital regime".

Liu said foreign companies can continue to repatriate their profits back to their own country but they now need to jump through re-established hoops and satisfy four criteria: to pay for any previous losses; gain board approval before repatriation; show no tax liabilities and, lastly; undergo a “proper” audit.

“These policies are basically aimed at slowing down China’s capital outflow," Liu said. “At the same time the PBOC is back on the offensive to try to attract renewed capital inflow.”

Last year, according to estimates by French investment bank Natixis SA, outflows totaled more than $US900 billion.

China basically opened its capital market for qualified foreign institutional investors (QFII) in February last year, however, in January, the People’s Bank of China (PBOC) made undeniable overtures to encourage foreign participation in China’s bond markets.

Beginning incrementally, the Chinese government has taken significant steps to further open up its financial markets and financial sector to foreign investment with a loophole offered around the more expensive offshore FX hedging solutions.

According to Liu, this puts a much-needed patch on a technical issue “that has been bothering foreign institutional investors”.

Onshore FX

At RMB 637 trillion, China’s domestic bond market is the third largest in the world and is likely to leapfrog Japan for the number two spot now China’s interbank bond market (CIBM) is allowing foreign institutional investors to enter into onshore FX risk hedging.

“If you go to China to own RMB bonds, either corporate or government bonds, you can only cash your currency offshore - but now the PBOC allows an onshore hedging for currency risk," said Liu.

This measure will effectively reduce hedging costs for foreign institutional investors invested in the China RMB market. The CIBM, effectively under the auspices of the central bank, accounts for nearly 90 per cent of the domestic bond market.

According to the State Administration of Foreign Exchange (SAFE), by the end of last year, 430 foreign investors held 870 billion yuan ($126.7 billion) of bonds in China’s interbank market, an increase of 83.4 billion yuan from a year earlier.

Against the controversy of exchange rate fluctuations, an ability to hedge FX exposure onshore helps address one of the biggest headaches institutional foreign players suffer when investing in China’s evolutionary domestic bond market.

Large, deep and efficient

Officials will be hoping, given time and experience, such reforms will make China’s bond markets more attractive for international investors and issuers, and ideally, scour a pathway for the inclusion of Chinese bonds in major global bond indices.

“The PBOC would like to get China capital markets in with the major global indexes this year, probably by June,” Liu said. “The MSCI will make the decision, perhaps toward the end of the year, and the three major global bond indexes will have to decide whether China’s bond market can be included."

This index inclusion will basically force institutional investors to look at China’s asset market.

The logic follows, Liu suggested, “if China’s bond market or equity market aren’t in the indexes that will eventually mean foreign institutional investors will have to own more RMB equity and RMB bond assets.”

And that, he said, is a way to attract renewed capital inflow into China.

“Short term, this renewed capital inflow will mitigate the current one way depreciation and stagnation of the RMB.”

In the medium term, foreign participation should means that China's bond market develops faster and become more efficient.

“With a large, deep and efficient bond market China could eventually liberalise its capital accounts we think probably by 2020, China’s capital accounts could be more open.”

By February, China's foreign exchange reserves were $US988.1 billion - below their peak of nearly $US4 trillion in June 2014 - but, according to Moody’s, are still “ample" relative to the country's external payment obligations.

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