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Photographer: Tomohiro Ohsumi/Bloomberg Photographer: Tomohiro Ohsumi/Bloomberg

China’s efforts to open up its domestic bond market, the world’s third largest, are starting to pay off, by pulling in foreign investors drawn to relatively high yields in a newly stable currency.

It’s a crucial step to balancing pressures on capital flows in and out of China, and if sustained would make it less risky for policy makers to relax controls on domestic companies and households taking money out of the country. It also helps China narrow the gap between its economy’s status as world No. 2 and its currency’s marginal role in the global financial system.

China pulled 346 billion yuan ($55 billion) of foreign funds into bonds in 2017, central bank data show. About one-third of the flows since the start of July came via the Bond Connect launched that month with Hong Kong, Bank of China (Hong Kong) Ltd. says.

While the total inflow is a fraction of the $337 billion of foreign net purchases of U.S. Treasuries for 2017 through November, it marks a 41 percent surge from 2016.

The acceleration will pick up this year, to 700 billion yuan, Deutsche Bank AG predicts.

Foreigners still hold less than 2 percent of China’s domestic debt, according to data compiled by Bloomberg. By comparison, foreigners hold 11 percent of Japan’s debt.

"We are definitely going to add allocation to Chinese onshore bonds this year -- China has become an attractive opportunity," said David Tan, chief investment officer of Asia Pacific fixed income at Allianz Global Investors Singapore Ltd. "The deleveraging has increased yields and nobody talks about yuan depreciation any more."

Small But Growing People's Bank of China, U.S. Treasury

Sustained inflows are potentially a game changer for China’s bond market. One hope is foreign investors will apply greater scrutiny to credit quality and demand more transparency on financial records, helping establish wider differentiation between stronger and weaker borrowers. They could also improve liquidity in onshore bonds, the bulk of which are held by banks and rarely traded compared with other major markets.

Linan Liu, a greater China rates and currency strategist at Deutsche Bank in Hong Kong, sees all of those dynamics "boosting the long-term prospects of renminbi internationalization." She says that "China is accelerating its financial integration with the global market."

Not everyone is convinced China’s market reforms have been enough to put it in the same set as other major bond markets for global fund managers. Critics point to the lack of an independent judiciary and the Communist Party’s dominance of all aspects of policy making, including the central bank, as a potential bar for some investors.

See here how one currency historian thinks the euro will be the dollar’s key rival, not the yuan.

Even so, the chance to buy three-year government notes at around 3.63 percent yield in China, versus 2.31 percent on comparable Treasuries and a negative 0.30 percent in Germany, is enough to tempt many.

"Interest in China’s onshore bonds is picking up from Europe, Southeast Asia, Middle East and even Africa," said Ken Hu, chief investment officer of Asia Pacific fixed income at Invesco Hong Kong Ltd. "The circulation of yuan offshore has increased, thanks to more trade with and investments from the country. People are looking for a place to invest their yuan holdings."

China has continuously opened up its onshore bond market over the past few years, first allowing institutional investors to register on the mainland, then starting in July letting fund managers buy in Hong Kong, via the Bond Connect.

Several changes are in the works to help the Bond Connect operate more effectively -- read about that here.

Similar to the way that China’s Stock Connect channels helped win onshore equities entry into global benchmarks, analysts anticipate the country’s bonds will at some point get included in world bond indexes. Deutsche Bank sees index inclusion helping pull in $700 to $800 billion of overseas funds over the next five years -- about 60 percent of that public funds, such as central bank purchases.

Government bonds are the top target for foreign investors, followed by certificates of deposit, according to data compiled by China Central Depository & Clearing Co. and Shanghai Clearing House.

( Updates yields in paragraph above second chart. )