March 7, 2017 / 4:27 PM / 9 months ago

Citi dips cautious toe in China bond pool

HONG KONG (Reuters) - Citi is playing a smart game with China’s government bond market. The U.S. bank on Tuesday said  it will include sovereign debt issued by the People’s Republic in three existing fixed-income indices – the first major international benchmark provider to do so. That’s a propaganda victory for Beijing, which has struggled to enthuse foreign investors. For Citi it’s a relatively low-risk diplomatic win.

People walk past a Citibank branch in Shanghai November 20, 2008. REUTERS/Aly Song

China has been trying to attract more foreign bond buyers since the International Monetary Fund designated the yuan as an official reserve currency last year. It’s been a tough sell. The country’s capital account is not fully open and regulation of financial markets remains ham-fisted. The yuan has also been sliding against the dollar, while rising long-term U.S. interest rates make Chinese yields less attractive.

Meanwhile, regulators’ efforts to squash capital outflows while encouraging inflows have made fund managers worry recent reforms are a honey trap. Foreign investors owned Chinese bonds worth just $126 billion at the end of 2016, according to the State Administration of Foreign Exchange – equivalent to less than 2 percent of the onshore bond market.

Adding China’s $1.1 trillion of government bonds to international benchmarks is therefore potentially a big deal. Funds which measure their performance against that index will have to increase their allocation to Chinese bonds. For example, the People’s Republic will account for almost 53 percent of the Citi index which tracks emerging-market sovereign debt.

The prospect of mechanically moving large amounts of cash into the People’s Republic is likely to unnerve fund managers. That is the main reason why MSCI has so far declined to include Chinese equities in its popular emerging market indices, despite the risk of upsetting Beijing.

Citi has skirted this conundrum by choosing indices which are not major benchmarks. Though the bank has not said how much money tracks its indices, the financial consequences are likely to be small.

There may be a tacit quid-pro-quo at work. A month ago, Chinese authorities granted Citi a bond settlement license. JPMorgan, which operates the leading emerging market bond index and is also contemplating including Chinese sovereign bonds, received a bond underwriting license around the same time. Watch this space.

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