* Bond investors can trade derivatives to hedge FX exposure
* Offshore investors remain cautious over market access
* Derivatives market still small with low trading liquidity
* New foreign investor rules likely to have limited market impact
By Umesh Desai and Winni Zhou
HONG KONG/SHANGHAI, March 1 (Reuters) - China’s move to open its derivatives market to foreign bond investors could help counter outflows but lingering concerns about capital controls are keeping offshore investors cautious.
The authorities have redoubled efforts to lure overseas investors and bump up bond market inflows after the relaxation of rules on foreign investment.
Such measures could potentially help China win inclusion on global bond indexes, but investors say market accessibility and concerns about the yuan’s stability could impede inflows.
“We don’t like the aspect of unclarity about the potential to move capital back out of the country,” said Maurice Meijers, Singapore CEO for Robeco, a Netherlands-based global asset manager with 276 billion euros in assets under management. Fundamentals and valuations were also concerns, he added.
“This feels like the wrong moment to get involved. Unless this market really starts to become part of the benchmark indices, it will stay like this for some time and I don’t expect major investors to jump in.”
The stakes are large. Standard Chartered estimated that the value of outstanding onshore bonds may rise to 82 trillion yuan ($11.93 trillion) by the end of this year from 64.3 trillion as of end-2016.
But foreign investment has been tiny. By the end of last year, foreigners held a mere 870 billion yuan worth of bonds in the Chinese market, an increase of 83.4 billion yuan from the year before, the State Administration of Foreign Exchange said.
That investment growth has arguably been stunted by government efforts to protect the yuan, which fell 6.5 percent against the dollar last year, prompting a barrage of measures that made it harder to move funds offshore.
AXA Investment Managers economist Aidan Yao said doubts about market accessibility and yuan depreciation were the main obstacles to attracting more flows.
Last year, the China Interbank Bond Market (CIBM) scheme liberalised the domestic bond market, encouraging foreign investors to invest in yuan products.
Even so, the nascency of the derivatives market could be an impediment, at least in the early stages.
“The derivatives market currently is still small in size with low trading liquidity,” said Ying Wang, senior director at Fitch ratings. “So this new rule allowing foreign investors to engage in derivatives is likely to have limited market impact.”
Besides providing a boost to inbound flows, authorities are also hoping it would lower funding costs for offshore investors.
Tommy Xie, an economist at OCBC Bank in Singapore, said investors who had previously been forced to use offshore yuan derivatives, could find cheaper alternatives.
“The offshore yuan pool has shrunk dramatically, and that has led to relatively huge volatility in the yuan lending rate and dollar swap rates. Uncertainty in financing costs has hurt foreign institutions’ interest in allocating more money in the domestic bond market,” he said.
In Singapore last week, Ma Jun, chief economist of the central bank’s research bureau, told investors the authorities were studying the possibility of extending trading times and settlement periods for foreign investors.
Such attempts to make the market more attractive could help China’s inclusion on global bond indexes - a boon that Goldman Sachs estimated could spur inflows of potentially $250 billion.
But it will be an uphill battle that may hinge much more on China’s macroeconomic fortunes.
Patrick Song, fund manager at CSOP Asset Management, said the latest steps were more symbolic at this stage.
“In the near term, we do not expect much inflows into China as there are concerns around policy uncertainty related to capital controls.”
$1 = 6.8756 Chinese yuan Additional reporting by John Ruwitch and Samuel Shen in SHANGHAI, and Vidya Ranganathan in SINGAPORE; Editing by Jacqueline Wong