## wp18253 ## Source details **Canonical URL:** [wp18253](https://www.imf.org/-/media/files/publications/wp/2018/wp18253.pdf) ## Other formats - [Markdown version](/-/media/files/publications/wp/2018/wp18253.pdf.md) - [Structured JSON version](/-/media/files/publications/wp/2018/wp18253.pdf.json) --- ### I. INTRODUCTION - China’s integration into global financial markets is increasingly central to global developments; financial integration follows trade and production integration. - Paper approach: - First half: benchmark China’s role in global financial markets against the United States, euro area, Japan, India, and Korea; analyze foreign participation in Chinese bonds and bond yield differentials (FX-hedged vs unhedged). - Second half: assess challenges of further international integration of the Chinese bond market, including sensitivity to U.S. monetary policy normalization and the global financial cycle. - Conclusion preview: ample room for further integration, especially in the bond market, but liberalization cannot occur in isolation from broader market and FX-market development. ### II. CHINA’S FINANCIAL MARKETS IN THE GLOBAL CONTEXT - Relative size and evolution: - Chinese bond market capitalization: about 1 percent of global GDP at start of 2000s; reached 9 percent by end of 2017. - Chinese stock market capitalization: about 2 percent of global GDP in 2002; reached about 10 percent in 2017. - Chinese banking system assets: from 1 percent of global GDP in 2002 to about 40 percent in 2017. - Foreign participation: - Chinese equity holdings by foreigners: about 2.4 percent of total Chinese equity market capitalization. - Foreign participation in Chinese bond markets: about 1.6 percent of the total value of bonds outstanding (stable in recent years). - International comparisons (foreign participation, 2017 unless specified): - Stock market foreign participation: United States about 35 percent; Korea 33 percent; Japan 17 percent; India 16 percent. - International investment position (2015): - China: liabilities to foreigners about 40 percent of domestic GDP. - United States: about 160 percent of GDP. - Japan: 115 percent of GDP. - Korea: 65 percent of GDP. - India: 55 percent of GDP. - Composition of external liabilities: portfolio equity and bonds represent 1/5 of total Chinese external liabilities, versus United States 3/4, Japan 3/5, Korea 3/5, India 2/5. ### III. FURTHER LIBERALIZATION OF CHINA’S BOND MARKET - Size and composition (end-2017): - Chinese bonds outstanding: about $11 trillion at the end of 2017. - Comparisons: Korea about $2 trillion; Japan $12 trillion; euro area $20 trillion; United States $41 trillion. - Issuers: Chinese bond issuers more concentrated in the nongovernment sector (including state-owned enterprises and government-sponsored vehicles). - Foreign holdings concentrated in government instruments. - Potential benefits of further liberalization: - Help private sector diversify funding, improve liquidity, and lengthen borrowing maturities. - Yield and hedging considerations: - Chinese government bond nominal yields higher than U.S. or euro area bonds; some degree of co-movement with global yields despite a closed capital account. - FX-hedged vs unhedged yield differentials: - Hedged China-foreign yield differentials are smaller than unhedged differentials. - Non-deliverable offshore forwards show higher hedging costs (less attractive) compared with onshore forwards. - Covered twelve-month vs three-month differentials suggest shorter maturity investments hedged onshore look somewhat more attractive. ### IV. MARKET OPENING AND INCREASING EXTERNAL INFLUENCES - External "push" factors affecting capital flows include U.S. monetary policy (including unconventional measures), risk aversion (U.S. VIX), and the U.S. dollar exchange rate. - 2017 dynamics: - Capital inflows to emerging and frontier markets rose in 2017 despite U.S. monetary policy tightening that began end-2015. - China experienced an increase in bank-related inflows (“other investment”) and to a lesser degree in portfolio equity and debt inflows. - Impact of U.S. unconventional monetary policy: - Estimates suggest expected steady Federal Reserve normalization could reduce portfolio flows by a cumulative $75 billion by late 2019 (model adapted from Koepke (2014), per IMF (2017a)). - U.S. dollar role and market positioning: - U.S. dollar depreciated against most currencies from early 2017 to early 2018; that depreciation was a driver of increasing capital inflows to emerging markets. - Market-implied expectations had priced in faster U.S. monetary tightening and narrower inflation differentials — forces that should have supported a stronger dollar but did not. - Speculative positioning: euro flipped from net short to net long after early 2017 appreciation; U.S. dollar heavily shorted more recently. By end-May 2018, the dollar had only partially reversed cumulative depreciation from early 2017 and positioning remained net short but at a lower level than end-2017. - Possible explanations for dollar depreciation: continued loose advanced-economy financial conditions fueling capital outflows; expected Fed balance-sheet reductions and larger future U.S. fiscal deficits implying absorption of U.S. dollar debt. ### V. SENSITIVITY OF CAPITAL INFLOWS TO THE GLOBAL FINANCIAL CYCLE - Current sensitivity: - China’s sensitivity to the global financial cycle is lower than other countries in portfolio flows, especially portfolio debt securities. - Based on Cerutti, Claessens, and Puy (2017): in China, just 5 percent of total variance in portfolio debt inflows is accounted for by a common global factor; average Asian emerging market economy: 18 percent; average of all emerging market economies: 13 percent. - Implication of further liberalization: - Further bond-market liberalization would likely elevate China’s sensitivity to the global financial cycle, given cross-country evidence linking greater foreign investor participation to higher sensitivity. - Equity inflows are less sensitive in this regard; China ranks in the middle of the emerging economy group for equity inflow sensitivity. - Empirical relationship illustrated: - Low bond inflow sensitivity is linked to relatively low participation of global investors; increased global investor exposure expected to raise sensitivity, similar to other countries. ### VI. CONCLUSION - Room remains substantial for further integration of China into the global bond market, which would advance sustainable integration into international trade and finance. - Trade-offs and policy implications: - Monetary autonomy: cost anticipated to be not large given China’s size and especially under a more flexible exchange rate framework supported by a well-articulated inflation-targeting framework. - Financial stability: more work needed by China and the IMF (IMF 2017b). - Domestic benefits: foreign capital inflows would help diversify funding, improve liquidity, maturities, and transparency in local bond markets; greater geographical diversification by Chinese resident financial asset holders would improve domestic asset allocations. - Global benefits: China’s large pool of savings, better integrated into international bond markets, could promote more productive allocation of world savings. - Transition note: greater exchange rate flexibility and an appropriate inflation-targeting framework require substantial progress and careful sequencing (referenced broadly to Obstfeld (2007) and essays in Ming and Schipke (2017)). *wp18253 - References (source PDF content).* ### References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ### References ### I. INTRODUCTION - China’s integration into global financial markets is increasingly central to global developments; financial integration follows trade and production integration. - Paper approach: - First half: benchmark China’s role in global financial markets against the United States, euro area, Japan, India, and Korea; analyze foreign participation in Chinese bonds and bond yield differentials (FX-hedged vs unhedged). - Second half: assess challenges of further international integration of the Chinese bond market, including sensitivity to U.S. monetary policy normalization and the global financial cycle. - Conclusion preview: ample room for further integration, especially in the bond market, but liberalization cannot occur in isolation from broader market and FX-market development. ### II. CHINA’S FINANCIAL MARKETS IN THE GLOBAL CONTEXT - Relative size and evolution: - Chinese bond market capitalization: about 1 percent of global GDP at start of 2000s; reached 9 percent by end of 2017. - Chinese stock market capitalization: about 2 percent of global GDP in 2002; reached about 10 percent in 2017. - Chinese banking system assets: from 1 percent of global GDP in 2002 to about 40 percent in 2017. - Foreign participation: - Chinese equity holdings by foreigners: about 2.4 percent of total Chinese equity market capitalization. - Foreign participation in Chinese bond markets: about 1.6 percent of the total value of bonds outstanding (stable in recent years). - International comparisons (foreign participation, 2017 unless specified): - Stock market foreign participation: United States about 35 percent; Korea 33 percent; Japan 17 percent; India 16 percent — substantially higher than China. - International investment position (2015): - China: liabilities to foreigners about 40 percent of domestic GDP. - United States: about 160 percent of GDP. - Japan: 115 percent of GDP. - Korea: 65 percent of GDP. - India: 55 percent of GDP. - Composition of external liabilities: portfolio equity and bonds represent 1/5 of total Chinese external liabilities, versus United States 3/4, Japan 3/5, Korea 3/5, India 2/5. ### III. FURTHER LIBERALIZATION OF CHINA’S BOND MARKET - Size and composition (end-2017): - Chinese bonds outstanding: about $11 trillion at the end of 2017. - Comparisons: Korea about $2 trillion; Japan $12 trillion; euro area $20 trillion; United States $41 trillion. - Issuers: Chinese bond issuers more concentrated in the nongovernment sector (including state-owned enterprises and government-sponsored vehicles). - Foreign holdings concentrated in government instruments. - Potential benefits of further liberalization: - Help private sector diversify funding, improve liquidity, and lengthen borrowing maturities. - Yield and hedging considerations: - Chinese government bond nominal yields higher than U.S. or euro area bonds; some degree of co-movement with global yields despite a closed capital account. - FX-hedged vs unhedged yield differentials: - Hedged China-foreign yield differentials are smaller than unhedged differentials. - Non-deliverable offshore forwards show higher hedging costs (less attractive) compared with onshore forwards. - Covered twelve-month vs three-month differentials suggest shorter maturity investments hedged onshore look somewhat more attractive. ### IV. MARKET OPENING AND INCREASING EXTERNAL INFLUENCES - External "push" factors affecting capital flows include U.S. monetary policy (including unconventional measures), risk aversion (U.S. VIX), and the U.S. dollar exchange rate. - 2017 dynamics: - Capital inflows to emerging and frontier markets rose in 2017 despite U.S. monetary policy tightening that began end-2015. - China experienced an increase in bank-related inflows (“other investment”) and to a lesser degree in portfolio equity and debt inflows. - Impact of U.S. unconventional monetary policy: - Estimates suggest expected steady Federal Reserve normalization could reduce portfolio flows by a cumulative $75 billion by late 2019 (model adapted from Koepke (2014), per IMF (2017a)). - U.S. dollar role: - U.S. dollar depreciated against most currencies from early 2017 to early 2018; that depreciation was a driver of increasing capital inflows to emerging markets. - Market-implied expectations (Eurodollar-Euribor futures and swap-implied inflation differentials) had priced in faster U.S. monetary tightening and narrower inflation differentials — forces that should have supported a stronger dollar but did not. - Speculative positioning: euro flipped from net short to net long after early 2017 appreciation; U.S. dollar heavily shorted more recently. By end-May 2018, the dollar had only partially reversed cumulative depreciation from early 2017 and positioning remained net short but at a lower level than end-2017. - Possible explanations for dollar depreciation: continued loose advanced-economy financial conditions fueling capital outflows; expected Fed balance-sheet reductions and larger future U.S. fiscal deficits implying absorption of U.S. dollar debt. ### V. SENSITIVITY OF CAPITAL INFLOWS TO THE GLOBAL FINANCIAL CYCLE - Current sensitivity: - China’s sensitivity to the global financial cycle is lower than other countries in portfolio flows, especially portfolio debt securities. - Based on Cerutti, Claessens, and Puy (2017): in China, just 5 percent of total variance in portfolio debt inflows is accounted for by a common global factor; average Asian emerging market economy: 18 percent; average of all emerging market economies: 13 percent. - Implication of further liberalization: - Further bond-market liberalization would likely elevate China’s sensitivity to the global financial cycle, given cross-country evidence linking greater foreign investor participation to higher sensitivity. - Equity inflows are less sensitive in this regard; China ranks in the middle of the emerging economy group for equity inflow sensitivity. - Empirical relationship illustrated: - Figure 13 analysis links low bond inflow sensitivity to relatively low participation of global investors; expectation that increased global investor exposure will raise sensitivity, similar to other countries. ### VI. CONCLUSION - Room remains substantial for further integration of China into the global bond market, which would advance sustainable integration into international trade and finance. - Trade-offs and policy implications: - Monetary autonomy: cost anticipated to be not large given China’s size and especially under a more flexible exchange rate framework supported by a well-articulated inflation-targeting framework. - Financial stability: more work needed by China and the IMF (IMF 2017b). - Domestic benefits: foreign capital inflows would help diversify funding, improve liquidity, maturities, and transparency in local bond markets; greater geographical diversification by Chinese resident financial asset holders would improve domestic asset allocations. - Global benefits: China’s large pool of savings, better integrated into international bond markets, could promote more productive allocation of world savings. - Transition note: greater exchange rate flexibility and an appropriate inflation-targeting framework require substantial progress and careful sequencing (referenced broadly to Obstfeld (2007) and essays in Ming and Schipke (2017)). *Italicized source attribution: wp18253 - References (source PDF content).* ### REFERENCES ### REFERENCES ### Works cited - Bayoumi, T. and F. Ohnsorge. 2013. “Do Inflows or Outflows Dominate? Global Implications of Capital Account Liberalization in China.” IMF Working Paper 13/189, IMF, Washington. - Bruno, Valentina and Hyun Song Shin. 2015. “Cross-Border Banking and Global Liquidity.” Review of Economic Studies82 (2): 535–564. - Cerutti, E., Claessens, S. and D. Puy. 2017. “Push Factors and Capital Flows to Emerging Coun- tries: Why Knowing Your Lender Matters More than Fundamentals.” Unpublished. - Cerutti, E., Claessens, S. and A. Rose. 2017. “How Important is the Global Financial Cycle? Evidence from Capital Flows.” IMF Working Paper 17/193. - Forbes, K. and F. Warnock. 2012. “Capital Flow Waves: Surges, Stops, Flight, and Retrenchment.” Journal of International Economics88 (2): 235–251 - Fratzscher, M., Lo Duca, M. and R. Straub. 2018. “On the International Spillovers of U.S. quanti- ative Easing.”Economic Journal608 (128): 330–377. - Guofeng, S. 2015.Financial Reforms in Modern China. A Frontbencher’s Perspective. New York: Palgrave Macmillan. - He, D., Cheung, L., Zhang, W. and T. Wu. 2012. “How Would Capital Account Liberalization Affect China’s Capital Flows and the Renminbi Real Exchange Rates?”China and World Economy20 (6): 29–54. - Hofmann, Boris, Shim, Ilhyock and Hyun Song Shin. 2017. “Sovereign Yields and the Risk- Taking Channel of Currency Appreciation.” Bank for International Settlements Working Pa- per 538, BIS, Basel (May revised version). - Hong Kong Exchange. 2017. “Tapping into China’s Domestic Bond Market—An International Perspective.” HKEx research report, May. - Hong Kong Exchange. 2018. “Bond Connect Celebrates First Anniversary” Press release, July 3, 2018. Available at https://www.hkex.com.hk/News/News-Release/2018/180703news?sc l ang= en - IMF. 2016. “The Growing Importance of Financial Spillovers from Emerging Market Economies.” Chapter 2 inGlobal Financial Stability Report. Washington, DC, April. - ———. 2017a. “Is Growth at Risk?” Chapter 1 inGlobal Financial Stability Report. Washington, DC, October. - ———. 2017b.People’s Republic of China: Financial System Stability Assessment. Washington, DC, December. - Koepke, R. 2014. “Fed Policy Expectations and Portfolio Flows to Emerging Markets.” Institute of International Finance Working Paper, Washington, DC. - Ma, G. and R. McCauley. 2014. “Financial Openness of China and India: Implications for Capital Account Liberalization.” Bruegel Working Paper 2014/05, Bruegel. - 16 - Ming, A. and A. Schipke, editors. 2017. “Strengthening Financial and Exchange Rate Frame- works: International Experience and Relevance for China.” Proceedings of the People’s Bank of China and IMF Fifth Joint Conference, Beijing. - Obstfeld, M.. 2007. “The Renminbi’s Dollar Peg at the Crossroads.”Monetary and Economic Studies, Institute for Monetary and Economic Studies, Bank of Japan 25 (S1): 29–56, De- cember. - Rey, H. 2016. “International Channels of Transmission of Monetary Policy and the Mundellian Trilemma.”IMF Economic Review64 (1): 6–35. *Source: wp18253 - REFERENCES.* --- _Source: https://www.imf.org/-/media/files/publications/wp/2018/wp18253.pdf_