China's Bond Market and Global Capital Flows

The aim of renminbi exchange rate reforms is to make supply and demand the determining factor in the market. That goal came a little closer with the reform of August 2015,a move that also effectively devalued the currency and gave a bigger role to the market in setting the currency's central parity rate. Looking ahead we will need to give greater weight to supply and demand in our forecasts for the direction of the currency.

At present we tend to give greater weight to demand without fully appreciating supply. We also tend to understate the importance of capital and financial items in the international payments. This article tries to look at the effects on the exchange rate from cross-border capital flows related to China's bond market,while examining the impact of the currency's inclusion in the International Monetary Fund's Special Drawing Rights,a basket of global reserve assets. It also examines the potential for a full opening of the domestic bond market to foreign participation.

Capital Inflows

The internationalization of the renminbi and the opening of the Chinese bond market may play a decisive role in capital flows. From 1990 to 2010,capital controls kept international capital from entering the domestic bond market. In the 1990s,the Chinese financial market was just gaining traction and decision makers chose the restrict inflows because they were uncertain of the impact of large amounts of capital. From 2003 to 2010,authorities chose to make a very gradual opening of the capital market,careful to avoid attracting more speculative funds. After 2010,the regulators felt more confident in permitting inflows of speculative capital along with the internationalization of the renminbi and the increasing convertibility of the capital account. The gradual opening took advantage of the expansion in global liquidity after the financial crisis and it presumed that foreign investors would want to enhance their holdings of financial assets as the Chinese economy powered ahead. Since then,foreign investors have steadily increased their holdings of renminbi assets. In early 2013,inflows of international capital to the bond markets of emerging economies in Asia - with the exception of China - slowed somewhat. China's attraction for foreign capital was clearly linked to the internationalization of the renminbi and the opening of the domestic bond market.

The renminbi's inclusion in the SDR currency basket,which formally took effect in October,has already had a positive effect on inflows of funds into the Chinese bond market. The addition of the renminbi to this elite club of reserve currencies will encourage foreign central banks and international organizations to hold more Chinese currency. That will mean increased purchases of renminbi bonds over the medium term. Data from the IMF shows the Japanese yen and the British pound sterling account for 4.5% and 4.7% of global foreign exchange reserves,respectively. Estimates for the next five years put the renminbi's share of global reserves at anywhere from 2% to 4%. That would mean that foreign central banks would hold US$460 billion worth of renminbi assets in the future,up from about US$100 billion now. With further steps toward internationalizing the renminbi and the government's efforts to facilitate purchases in the Chinese bond market,there will be even more of an inflow of global funds from mutual funds,pensions,insurance companies,commercial banks and other institutions.

China is an important part of the global bond market. The Chinese market's attractiveness to foreign capital reflects factors that apply to other Asian emerging economies. If the Chinese economy continues to grow at a faster pace than many other economies and domestic interest rates remain above offshore levels,there will be continued inflows of capital. The financial crisis of 2008-2009 and the easier monetary policies that followed the crisis have been the key reasons for the upsurge in global liquidity. Since 1990,the inflows of international capital into the bond markets of Asian emerging economies including China have undergone three distinct waves. Over 25 years,each period of capital inflows would last six years,and inflows equate to 0.65% of GDP; the average period of outflows of international capital is two years and the ratio of outflows to GDP is 0.20%. Inflows of international capital into the bond markets in 2015 were at the lowest point of the cycle,which means there is hope that we could see a new cycle soon.

Cyclical and structural factors should all be considered when assessing the potential inflows of international capital into the Chinese bond market. In 2010,the opening of China's bond market coincided with an upsurge in global liquidity that stemmed from the loose monetary policies put in place after the fina