Bond hedging: China must be bolder

Beijing needs to be bolder in reform of its bond market if widespread acceptance of Chinese government bonds (CGBs) as collateral is to really take hold.

It is true foreign appetite for CGBs doesn’t appear to be waning; overseas holdings of the instruments reached a record $340 billion at the end of August, according to data from the China Central Depository & Clearing.

But much of this increase is a reflection of the times in which we live: the yield on a 10-year US treasury bond is currently 1.25%, compared with 2.8% for a 10-year CGB, according to data from Bloomberg.

For this trend to be sustained in the future, Chinese authorities need to be prepared to hand foreigners a better way of managing interest rate risk.

While it is possible to hedge using onshore interest rate swaps, the market is only really liquid up to about three or five years. What international investors really want is the ability to access the bond futures market. But for now, they can’t.

With money still pouring into China’s fixed income market, now would be the ideal time to doff the cap to foreigners and give them what they want. But this isn’t as easy as it sounds. Folk in the upper echelons of the regime have long memories.

In 1995, following a bond trading scandal that brought down the biggest securities firm in the country, Shanghai Wanguo Securities, responsibility for the bond market was dialled all the way up to the highest authority in the land, the State Council. It has never come back down.

This has hampered reforms and, for a quarter of a century, the country’s banks have not been able to trade bond futures.

It looked as though this might have been about to change in February last year, when authorities did finally reopen the bond futures market for local players. But two months later they lost their nerve as a $1 billion trading failure (unrelated to the reforms) hit the Bank of China. They wrote to the major banks advising them not to trade bond futures.

If the authorities are so jittery about allowing domestic firms to play in the market, it doesn’t seem terribly likely that they’re about to start letting foreigners, over whom they have even less control, in.

Global interest in Chinese bonds is not about to disappear, but Beijing should be careful not to miss the opportunity that current buoyancy in the markets affords: to push ahead with those reforms it has been putting off for decades

The need for foreigners to effectively manage yield curve risk was brought into sharp relief in late July, when news of new regulatory crackdowns on private tutoring companies sparked a sell-off in Chinese stocks. Foreign investors in Chinese bonds were
also spooked.

As positions were liquidated, the yield on the benchmark 10-year CGB increased by seven basis points to 2.94%, its largest single-day move in more than a year.

While the panic was short-lived, by the following day aggressive buying onshore and opportunistic punts from global investors had almost completely reversed the movement – the incident does underscore the kind of volatility investors are likely to encounter in the renminbi bond market.

Global interest in Chinese bonds is not about to disappear, but Beijing should be careful not to miss the opportunity that current buoyancy in the markets affords: to push ahead with those reforms it has been putting off for decades.

This would give a further boost to growth of the country’s bond market. But even more importantly – at least from a risk management  point of view – it will give foreign institutions a greater reason to accept CGBs as collateral.

In September, a number of Chinese securities houses and other financial entities came in scope for posting initial margin, under the fifth wave of the global rules. It would be much better for them if they could post CGBs rather than, for example, US Treasuries, which they might not naturally have on their balance sheet.

But any foreign firm – or regulator – that is happy for derivatives trades to be backed by CGBs needs to think carefully about how the yield curve risk should be managed.

Beijing would do well to think about that, too.