Explainer: Why China's inclusion in benchmarks of global bonds is important

HONG KONG (Reuters) – Chinese-denominated Chinese onshore bonds will start to be included in the Bloomberg Barclays Global Aggregate index as of Monday, and two more competing indices will soon follow.

Significant inclusion is expected to attract billions of foreign dollars to the $ 13 trillion Chinese bond market, the world's third-largest market.

This is why investors around the world are watching this closely:

WHAT SUPPLIERS OF INDEX ADD CHINESE BONDS AND WHEN?

After years of anticipation, the benchmark global bond indices are finally integrating China, attracting many investors – some for the first time – in this vast market.

On April 1, the Bloomberg Barclays Global Aggregate Index will start adding Chinese government and bank bonds over 20 months. Inclusion will eventually put China's weight in the index at 6.03%, Bloomberg said in January.

Chinese government bonds are also part of the "watch list" of bonds to join the FTSE Russell World Government Bond Index (WGBI), which is expected to be reviewed in September, the index provider said.

China has been placed on watch list of the JP Morgan Emerging Markets Bond Index, Global Diversified, the other bond benchmark in 2016. JP Morgan will review the reactions of the Investors on inclusion at its annual meeting this summer, said a spokeswoman for the bank.

WHY NOW?

Analysts have long argued that the Chinese bond market, the world's third largest market, was too important to ignore. But restrictions have prevented many investors from using Chinese bonds.

Over the years, China has facilitated access to foreign investors, including launching the Bond Connect program in 2017, which allows investors to buy and sell onshore bonds via Hong Kong.

In the past year, the authorities have added two key features: delivery versus payment and bulk transactions, common features of financial markets elsewhere. Beijing has also clarified how it will tax Chinese investors' gains on Chinese bonds.

Bloomberg has prescribed the introduction of these three characteristics in March 2018 as prerequisites for inclusion in an index.

How much money will it bring to China?

The aggregated global index is followed by about $ 2.5 trillion in portfolio badets under management. A 6% weighting would yield $ 150 billion in Chinese fixed income securities, according to HSBC and several other banks.

However, Goldman Sachs has reduced its forecast budget between $ 120 and $ 150 billion in February, noting that 10 to 20% of investors may not be ready to follow the first day's index because of operational and other difficulties. . Standard Chartered made a similar observation.

In a report released last month, Deutsche Bank also estimated its cash flow at $ 120 billion, but came to this conclusion baduming that the Global Aggregate is followed by a pool of pbadive badets. 2 trillion dollars.

A 5% inclusion in WGBI will result in additional inflows of $ 125 billion, and a 10% inclusion in JP Morgan's benchmark could yield an additional $ 22 billion to China, HSBC said.

WHAT IS INVESTORS LOOKING FOR?

Chinese government bonds recently issued tend to be much less actively traded, or "liquid," once a new group of issues arrives. This could make replication of the inclusion portfolio difficult for index investors, said ASIFMA, a financial sector lobby group.

The toolbox for managing interest rate risks is also limited. Hedging instruments such as bond futures and repo transactions are open only by certain foreign investors, said ASIFMA, which also called for wider liberalization of the derivatives market.

With Chinese bonds accounting for just 6% of the aggregated aggregate index, most investors seem happy to ignore these shortcomings, although this may change if the country's weight in global indices rises.