The launch of China’s Bond Connect program could have a profound impact on multiple facets of Chinese monetary policy by giving overseas investors access to the country’s $10 trillion bond market.
Writing for Bloomberg, Ben Emons notes that China’s monetary policy can be hard to grasp given that its remit covers multiple objectives, including economic growth, inflation, exchange rates as well as financial stability.
Any adjustments to one area of monetary policy will thus have an impact on other areas, as demonstrated by mounting credit levels that China is currently seeking to curb, which first began to burgeon in late 2015 after PBOC shifted its focus from reserve requirement ratios to yuan management.
With Goldman Sachs expecting Bond Connect to bring as much as $1 trillion in extra global fixed investment to China’s domestic bond market, and Deutsche Bank, seeing inflows of foreign capital reaching $700 – $800 billion over the next five years, Emon believes this influx of foreign funds will likely shift the focus PBOC policy to inflation and growth targeting.
“With MSCI’s decision to include Chinese A shares in its benchmark indexes and the China bond connect program now in effect, PBOC policy is likely to shift further away from proactive currency management towards a focus on economic fundamentals,” he writes.
PBOC will also have to indicate more clearly convey its stance on these growth, inflation and employment given the high sensitivity of Chinese bonds manufacturing, producer price and production data, according to research produced by the Federal Reserve Bank of New York.
According to Emon this will have major ramifications for Chinese sovereign bonds, given that they the correlation with short-term repo rates has left them with a very negative term premium – a situation which could change, however, should foreign money flows restore re-invert the yield curve.
“Prior to capital controls and the devaluation of the yuan in August 2015, the onshore and offshore yield curves were closely aligned, implying rate and inflation expectations weren’t all that influenced by efforts to manage the exchange rate,” writes Emon. “Foreign capital inflows could offset domestic capital outflows, lessening the need to manipulate short-term interest rates to control the yuan.”
Bond connect and the access to China’s debt market that it creates could also raise the correlation between Chinese and global interest rates and make them another benchmark of influence, increasing the international impact of any shift in PBOC policy towards inflation and growth.