HONG KONG (Reuters) - China's policymakers plan to open the doors wider than ever to foreign investment in the country's $3 trillion bond market, in part to help shore up the struggling yuan. But the currency is also proving to be a major barrier to the success of their plan.
Foreigners own less than 2 percent of China's $3.3 trillion in outstanding bonds and say getting their cash out of China and recent weakness of the closely controlled currency are obstacles to investment.
Foreign investors are also skeptical they can assess risk accurately when most of the $2.1 trillion in corporate bonds are rated investment grade by domestic rating agencies.
Chinese bonds offer their highest yields in two years and, on the basis of 10-year sovereign debt, the biggest interest rate gap with equivalent U.S. Treasuries in eight months, highlighting the dilemma of a market that is appealing on the one hand but on the other considered to carry too many risks.
"If investors wanted to have more exposure to Chinese bonds, we can do it tomorrow," said Andy Seaman, a partner and chief investment officer of London-based fund manager Stratton Street.
"But unfortunately, they don't. It's very difficult to persuade people because of the currency. They don't want renminbi," he said.
While China's measures to clamp down on capital outflows to reduce pressure on the yuan have captured the headlines since late last year, the country has also been opening up its bond market and liberalizing its financial derivatives, aiming to draw money into the country.
Premier Li Keqiang said in March that China was considering setting up a trading link with Hong Kong this year, similar to one already used to trade stocks, which would give foreign investors much easier access to the world’s third-biggest bond market.
Chinese bonds have been included in some more narrowly focused indexes run by Citigroup and Bloomberg and before opening up its bond market China had allowed quota-based foreign investment. China Central Bank Governor Zhou Xiaochuan has said officials would work to open the market further.
"We don't intentionally seek the inclusion of yuan bonds into any particular bond index, but will push forward in this direction on a steady basis," he said in March.
A senior Hong Kong central bank official, familiar with mainland thinking, said the trading link plan and other reforms are aimed at addressing concerns by bond index providers about investors' ability to access Chinese bond markets.
"China knows that quota-based allocations to foreign investors are not very attractive to bond investors and these steps will allow foreign institutions to buy onshore debt sitting comfortably from their offices in Hong Kong or Singapore," the official said. He declined to be identified because he was not authorized to talk to the media.
While these measures might provide easier access for foreign investors to China's bond market, the yuan is no longer a one-way appreciation bet. It fell almost 7 percent in 2016, its biggest decline since a revaluation against the dollar in 2005.
Introducing more currency volatility has helped Chinese authorities shake off speculators, but it has also pushed other investors away too.
Stratton Street's Renminbi Bond Fund, which enables clients to profit from potential yuan appreciation and Asian bond yields, has shrunk by around 80 percent to $70 million since its peak of $380 million in 2012.
An analysis of offshore yuan-denominated bond funds compiled by Morningstar shows total assets under management shrank by nearly half in the last year to about $11.6 billion.
The yuan's outlook against the dollar "remains a hurdle for significant inflows into China's bond markets," said Rohit Arora, a UBS strategist in Singapore.
A Reuters poll conducted in the past week found the yuan is forecast to weaken to 7.07 against the dollar in a year. It was changing hands at 6.91 per dollar on Tuesday.
Analysts and China state media hailed the inclusion of Chinese bonds in three Citigroup government bond indexes as a milestone. But the investment bank stopped short of including them in its widely followed World Government Bond Index (WGBI), which tracks assets of between $2 trillion and $4 trillion.
Inclusion could draw capital inflows into China of hundreds of billions of dollars, HSBC analysts say.
But that may be some time in coming, said Lewis Emmons, principal at Mercer Investment Solutions in Singapore.
"The recent creation of new 'halfway house indices' potentially prolongs the horizon for full inclusion of China bonds in the most common indices," he said.
"Investors still need assurances about their ability to move cash in and out of China."
Reporting by Saikat Chatterjee and Umesh DesaI; additional reporting by Samuel Shen in SHANGHAI; Editing by Neil Fullick