Foreign players in China's debt market could force long overdue change. Photo: iStock

Maybe the globe has been going at this “Change China” thing from the wrong direction. Maybe top-down negotiations are not the way forward. Maybe – just maybe – it will be a market-based, bottom-up approach that will do the job.

While US President Donald Trump’s trade war aims at altering the mechanics of China Inc from the top down, efforts to forge a truce are ongoing. On Friday, negotiators wrapped up two days of US-China trade talks – talks that US President Trump’s team called “candid and constructive.”

Officials are now scrutinizing English and Chinese texts of a proposed deal set to end a 12-month brawl over tariffs.

Next week, Chinese Premier Li Keqiang heads to Washington for more dialog. Opening the Boao Forum for Asia last Thursday, Li reassured the globe that China will avoid a deep slowdown, while continuing to open its economy. Beijing, he said, is working to “operationalize” a new foreign investment law to allow greater access to China’s energy, healthcare, telecoms, infrastructure, transportation and other sectors.

But the vagueness of regulations is dampening hopes for a “big bang.”

As Allison Sherlock of Eurasia Group points out, new revisions to the law uphold legal distinctions between domestic and foreign enterprises, leaving foreigners “vulnerable to discriminatory policies.” Also, its expansive definition of “national security” grants Beijing wide latitude to block investments.

“Li’s oftentimes earnest efforts to improve the business environment cannot overcome broader political tightening, and the slow trickle of policies and rule-writing underlines feelings of government inefficacy,” Sherlock says.

Similar concerns hovered over this week’s trade talks in Beijing. As the focus turned to language, phrasing and the meanings of certain words, investors are safe to assume any deal will be larded with loopholes China can use to limit foreign access.

And then there’s Trump’s desperation for a win – any win – on the world stage. That ups the odds that China will agree to buy a few extra tankers’ worth of US goods each month, make vague pledges on intellectual-property rights, and move on.

But a look at China’s bond market suggests a ground-up approach will do more to shake up Asia’s most-watched financial system.

Here comes the Trojan horse

On Monday, China’s giant $13 trillion onshore debt market will, for the first time, be included in a major global index. That means a sudden influx of overseas fund managers shoving at least $100 billion into mainland debt this year. That will make global punters key shareholders in China Inc.

And this is critical. Initial dollar amounts aren’t the point. Users of the Bloomberg Barclays Global Aggregate Index are now set to scrutinize Xi Jinping’s reforms in unprecedented ways. Capital inflows won’t be from central banks or sovereign wealth funds – but from talkative global punters who appear on CNBC, Bloomberg TV and Fox Business on a daily basis.

It will be troubling for Xi’s team if traders and strategists highlight troubles related to dealing in the market. Or if there are complaints about transparency, the settlement of transactions or difficulty in discerning the identity of counterparties. Or if liquidity constraints have them thinking twice about increasing exposure to Xi’s China. All potential embarrassments.

Call if the “Trojan horse strategy” – one championed by Zhou Xiaochuan, Beijing’s most important reformer of the last 15 years. From 2002 to 2018, Zhou ran the People’s Bank of China. There, he used his gravitas to prod Xi and predecessor Hu Jintao to welcome potent change agents into China’s walls.

Among the biggest: getting the yuan included in the International Monetary Fund’s reserve-currency club. For Zhou, that meant convincing the team of IMF head Christine Lagarde to welcome the yuan into the top-five currency matrix. It also meant winning Xi’s approval. That’s because once inside China’s walls, the IMF’s edicts for greater transparency and convertibility forced China’s hand. Any failure to raise China’s game accordingly could prove embarrassing for Beijing.

Zhou learned the Trojan horse move from his mentor, former Premier Zhu Rongji. China’s No. 2 official from 1998 to 2003 shepherded the economy into the World Trade Organization. It opened China in unprecedented ways from which there was no turning back. Having the yuan included in the IMF’s “special-drawing rights” program is having a similar effect.

Financial vigilantes inbound

So will increased foreign participation in the bond market. Deutsche Bank, for example, reckons that overseas investors could own a fifth of Beijing’s government IOUs within five years. That will unleash a “bond vigilante” dynamic to which Xi’s China isn’t accustomed.

The reference here is to the acerbic cast of characters who protest fiscal or monetary policies they deem wrongheaded. They’re the ones pushing US 10-year yields below three-month rates – known as an “inverted yield curve” – and letting Washington know something’s amiss. And the foreign vigilantes could prove a thorn in Beijing’s side if reforms don’t keep pace with foreign inflows.

Already, global bond funds are calling on Beijing to provide more market data, accelerate registration procedures and increase the availability and sophistication of hedging tools. They are reminding Chinese regulators they will withdraw from the mainland market if progress lags.

At the moment, these voices hold just over 2% of Chinese debt. As that share increases, and exponentially so, Beijing will be forced to listen. Beijing also will have a harder time dictating borrow-cost levels and where liquidity flows.

Until now, Beijing’s control over interbank funding dynamics, the capital account and daily yuan reference rates was absolute. Any abrupt policy changes will now have greater impact and greater risks of provoking capital outflows.

Top-down trade talks are continuing, and that’s a positive for global markets. On Friday, stocks in Shanghai and Shenzhen enjoyed 3%-plus rallies on hopes good news is forthcoming.

All this means that, no matter what top-down deal Trump and Xi strike, there are already forces at play prodding China to let markets play a decisive role. Those vigilantes are poised to agitate for change from the ground up.

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