Goldman Sachs: This reform would stem much of China’s net outflows

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China has labored under continuous outflows the past couple years, but reforming its bond market could reverse the current, Goldman Sachs said in a note on Wednesday.

The fund outflows have been large. Evidence of that is seen in China's foreign exchange reserves, which fell in January by $12.3 billion to just under $3 trillion, the first time below that mark in nearly six years, Reuters reported earlier this month. That followed a $41 billion drop in December, the report said.

In 2016, China's reserves fell by $320 billion, after dropping $513 billion in 2015, it said.

But Goldman said China could stem the net outflow through its bond market, as while it's the third-largest government bond market globally, with $1.7 trillion of value outstanding, it isn't included in any major global bond index because of the country's capital controls.

"One way China can induce natural inflows is to further liberalize its onshore bond market, and by doing so it could become eligible for inclusion into the major global bond indices," it said. "As a consequence, benchmarked funds would then have to allocate to China, as part of their index tracking process."

If China's bond market were included in three major global bond indexes — the JPMorgan GBI-Emerging Markets Global Diversified, the Bloomberg Barclays Global Aggregate and the Citi World Government Bond Index — Goldman estimated aggregate inflows of around $250 billion.

It added that there could be another $10 billion in inflows from a spill-over effect from cross-over and total return funds and other Asian bond indexes.
"In practice, if China's bond market is fully liberalized, then it should attract other inflows such as foreign banks' balance sheet desks and trading desk flows. This flow could be substantial," it said.

"The authorities should welcome these flows, as they are sticky," Goldman said.

It expected that the process for China's bonds to be included in the indexes would take from two to five years with the main hurdles coming from market access, hedging, liquidity and concerns over repatriation.

But Goldman noted that even the $250 billion in potential inflows from index inclusions wouldn't fully solve the issues with net outflows.

—By CNBC.Com's Leslie Shaffer; Follow her on Twitter @LeslieShaffer1

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