What you need to know about China's "Q-expansion"

In recent days, China has approved 32 foreign institutions to invest in its domestic bond market worth USD 5.9 tn, mainly via the QFII (Qualified Foreign Institutional Investor) and RQFII (Renminbi Qualified Foreign Institutional Investor) schemes.

This “Q-expansion” is part of Beijing’s long-term commitment to open China’s capital account, towards which momentum continues to build. Table 1 summarises the recent developments.

QFII and RQFII are the two major channels through which to access the onshore capital market (both stocks and bonds). Although the QFII program has grown slowly since its inception in 2002, it received a significant boost last year from rapid and sizable approvals.

Meanwhile, the quota on the much newer RQFII program, which was launched in late 2011, has quickly increased to a sizable RMB 360 bn. Prior to the latest approvals, 268 QFIIs and 121 RQFIIs had been approved. Offshore institutions currently hold RMB 579 bn (USD 93 bn) in interbank bonds as of Mar15, up 44% YoY (Chart 1).

Ongoing capital account liberalisation has lifted the popularity of the yuan which is increasingly being held by not only financial institutions but by a growing number of central banks as well.

In particular, the UK last year raised RMB 3 bn via the landmark issuance of an offshore sovereign yuan bond. The proceeds were held as foreign reserves rather than converted into dollars or euros.

The ECB has also laid the groundwork to add yuan to its forex reserves. Australia’s central bank has acknowledged a 3% allocation of its forex reserves to yuan.

To date, more than 50 central banks, sovereign institutions, and supranationals have invested in yuan either through QFII / RQFII schemes, the China Interbank Bond Market (CIBM), or offshore CNH markets.

Such investment will only accelerate when the yuan becomes part of the IMF’s Special Drawing Rights (SDR), which seems likely to occur this year.

Challenges

As more public and private investors add yuan to their portfolios, pressure will grow on Beijing to speed up financial market reforms. Going forward, policies will need to address challenges such as market fragmentation, insufficient information disclosure, and the absence of properly-functioning yield curve.

Developing a deep and liquid bond market is key to a more efficient allocation of capital. Specifically, a fully-functioning bond market enables banks to increase their lending to households and SMEs.

Yet, the current development of the China’s bond market does not match the country’s economic strength. Bond market capitalisation amount to only around 50% of China’s GDP; roughly one-third as high as in the US.

Meanwhile, it is not practical for the yuan to become a reserve currency if foreigners’ bond holdings count for only 2% of domestic bond holdings. Hence, if the yuan to continue growing as a reserve currency, further access to domestic markets is needed.

Fewer yuan offshore?

In the short-run, however, more inflows into onshore instruments – through avenues such as RQFII, the Shanghai-Hong Kong Stock Connect, and the anticipated Shenzhen-Hong Kong Stock Connect – may mean tighter offshore liquidity pool.

Broadening channels of yuan supply to the offshore market is needed to achieve more balanced flows between Hong Kong and China over the longer-term.

In a statement at the 31st meeting of the International Monetary and Financial Committee held in Washington in April, the PBoC’s governor Zhou Xiaochuan said that China will further expand cross-border investment channels for individual investors, such as via the pilot program of Qualified Domestic Individual Investor.

Apart from boosting offshore liquidity, such measures would help China achieve better balance between inflow and outflow.

In short, for the yuan to become a more common and widely held reserve currency there needs to be greater access for foreign investors in domestic capital markets, a larger offshore yuan liquidity pool, and wider cross-border flow channels. All are developing more quickly than most envisioned just one or two years ago.