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Cerutti and Obstfeld are both at the Research Department of the International Monetary Fund (IMF). This paper is a chapter of the forthcoming book “China’s Bond Market Taken Off: Characteristics, Prospects, and Reform,” edited by Alfred Schipke, Markus Rodlauer, and Zhang Longmei. We are grateful to Qianying Chen, Sally Chen, Sophia Chen, Ziya Gorpe, Henry Hoyle, Deniz Igan, Sole Martinez Peria, Hui Miao, Lev Ratnovski, Alfred Schipke, Yu Shi, Jochen Schmittmann for comments, and to Haonan Zhou for superb help with the data and figures. Emails: firstname.lastname@example.org, email@example.com. The opinions expressed herein are solely the responsibility of the authors and should not be interpreted as reflecting those of the IMF, its Executive Board, or IMF management.
Guofeng (2015) describes the recent reforms. The inclusion of around 230 mainland-listed stocks in the MSCI index took effect on June 1, 2018. At the beginning, the share of Chinese A-shares would be about 0.7 percent of the MSCI index, with a future full inclusion weight of about 18 percent. Whereas Chinese bonds are not now included in any global index, if included, their index weight would be about one-third of the widely followed J.P. Morgan Emerging Markets Bond Index Global, according to the IMF (2016).
As in the case of other countries, foreign investors could also increase exposure to a particular country through off-shore markets. In the case of China, this is especially the case through the off-shore markets operating in Hong Kong, where bonds can be also issued in renminbi (usually known as Dim Sum bonds). Nonetheless, the small foreign participation in the Chinese onshore bond market does not seem to be driven by the availability of bonds in these offshore markets. In addition to maturity considerations (that is, often shorter maturity in offshore markets), the activity in these offshore markets is influenced by both the offshore issuance of bonds by Chinese companies that need to be authorized by the National Development and Reform Commission (China’s economic planning ministry and regulator for enterprise bonds), and also net renminbi outflows from the mainland, which provides a large part of the liquidity and are also regulated from the mainland. Moreover, the launch of the Bond Connect program—which liberalizes some regulations by allowing institutional international investors to trade onshore bonds through Hong Kong—has increased foreign holdings in onshore markets in 2018 according to Hong Kong Exchange (2018).
The May 2017 Research Report of the Hong Kong Exchange finds that foreign financial institutions tend predominantly to hold Chinese sovereign bonds and the most highly rated corporate bonds as part of their renminbi reserves due to China’s weak market infrastructure, particularly the rather low credibility of local credit rating agencies.
Ma and McCauley (2014) also document that the renminbi is priced cheaper onshore than offshore in the foreign exchange forward markets (as in Figure 8 as the higher cost of hedging using non-deliverable forwards compared with onshore forwards), and they associate this phenomenon with an appreciation of the renminbi and net private capital inflow pressures whenever the capital account opens up in China. Their projections for net inflows contrast with both He et al. (2012) and Bayoumi and Ohnsorge (2013), who project large increases in gross external positions (both assets and liabilities) but with private assets increasing more than liabilities. Estimating the net impact of further financial market liberalization is beyond the objectives of the paper and constitutes a very difficult task given the complexity and that relationships estimated with historical data would not necessarily be good predictors of the final direction of capital flows after structural policy changes—which, in any case, will not necessarily be implemented all at once.
As IMF 2017a highlights, estimates for portfolio flows are obtained using a model adapted from Koepke (2014). The model estimates the impact of external “push” and domestic “pull” variables on portfolio flows to emerging markets, consistent with the capital flows literature. The dependent variable reflects monthly data from the Institute of International Finance on nonresident portfolio flows to emerging market economies (that is, foreign purchases of emerging market stocks and bonds). Independent variables aim to capture push factors and pull factors. Push variables include a proxy for global risk aversion (either the U.S. corporate BBB spread over Treasuries or the U.S. VIX), three-year-ahead expectations for the effective federal funds rate, and the change in assets held on the Federal Reserve’s balance sheet. Pull variables include an emerging market economic surprise index compiled by Citigroup and the Morgan Stanley Capital International Emerging Markets Index.
The traditional (risk-neutral) uncovered interest rate parity formula can be written as:
Greater flexibility is often cited inside and outside of China, but much progress remains to be made. Transition could proceed along broad lines as laid out in Obstfeld (2007), with due attention to the need to refine an appropriate inflation-targeting framework, as discussed in several of the essays in Ming and Schipke (2017).