China's $13 trillion bond market marks a milestone. Here's what it means

  • Starting Monday, 364 onshore Chinese bonds will be added to the Bloomberg Barclays Global Aggregate Index over the next 20 months.
  • Analysts estimate that the full inclusion will attract around $150 billion of foreign inflows into China's roughly $13 trillion bond market — the third-largest in the world after the U.S. and Japan.
  • The inflows will help support the Chinese yuan at a time when China's current account surplus is shrinking, said Khoon Goh, the head of Asia research at ANZ Bank.

Domestic Chinese bonds became part of a major global index on Monday, marking another milestone in the opening up of China's financial markets.

Hundreds of onshore Chinese bonds will be added to the Bloomberg Barclays Global Aggregate Index over the next 20 months. Analysts estimated that the full inclusion will attract around $150 billion of foreign inflows into China's roughly $13 trillion bond market — the third-largest in the world after the U.S. and Japan.

The index inclusion is the latest step in the opening up of China's financial markets to global investors. Last year, Chinese A-shares — yuan-denominated stocks traded on the mainland — were included in the MSCI Emerging Markets Index. China has also launched "connect" programs that allow investors to buy certain shares and bonds through Hong Kong's stock market.

"Today marks an important milestone as China's capital markets continue to find their place in the global investment mainstream," said Justin Chan, HSBC's co-head of global markets in Asia Pacific.

Which bonds are included?

The Bloomberg Barclays Global Aggregate Index will add 364 bonds issued by the Chinese government and the so-called "policy banks" — or lenders set up to support the government's development plans and policies.

Here is the breakdown of the bonds set to be included in the index:

  • Chinese government — 159
  • China Development Bank — 102
  • Agricultural Development Bank of China — 58
  • Export-Import Bank of China — 45

When the bonds are fully added into the global benchmark, China's weight in the index will increase to around 6 percent and the Chinese yuan will become the fourth-largest currency component, according to Bloomberg.

What is the significance?

Despite its large size, Chinese bonds are under-owned by global investors. Analysts estimate that foreign holding of Chinese debt stands at only 2 percent of the $13 trillion in total value.

In particular, Chinese central government bonds have the highest foreign ownership at close to 8 percent, noted Khoon Goh, head of Asia research at ANZ bank, in a Monday report. But that's still "very low" compared to 35 percent for U.S. Treasurys and 28 percent for British government debt.

Being added into the Bloomberg Barclays Global Aggregate Index will change things. The index is widely tracked by asset managers globally, which means they will seek to replicate the benchmark's holdings and performance and tweak the components of their funds to include Chinese bonds.

And it doesn't stop there. Several other key index providers are also considering whether to add Chinese bonds into their benchmarks. They include the J.P. Morgan Government Bond Index-Emerging Markets and the FTSE World Government Bond Index.

The inclusion of Chinese bonds into various indexes will push China to further reform its financial markets, said Neeraj Seth, managing director and head of Asian fixed income at global investment management firm BlackRock on Monday.

"More opening up of the financial sector, reforms with regards to how you manage credit risk, more development of the derivatives market onshore — all that will continue, which will further pave the path for both index inclusion as well as entry of foreign investors into this market," he told CNBC's "Squawk Box."

Implications for the yuan

More foreign investors buying Chinese assets will mean greater demand for the yuan.

ANZ's Goh estimated that China would receive as much as $275 billion in foreign inflows as a result of its bonds being added to indexes by Bloomberg, J.P. Morgan and FTSE. That would help increase the Chinese yuan's share in foreign currency reserves held by central banks globally, he added.

Without such inflows, the Chinese yuan would come under pressure as structural changes within China are expected to shrink its current account surplus. A current account surplus occurs when the total value of goods, services and investments that a country exports exceeds what it imports.

Morgan Stanley predicted in a February report that China's current account could turn into a deficit this year. That means the Asian economic giant would have to attract more foreign money to fund its needs. The last time China had a current account deficit was in 1993.

Such a development would put the Chinese yuan under pressure, noted Goh. But, "given the structural increase in foreign portfolio inflows over the next few years, we expect the yuan to stay supported," he added.

— CNBC's Kelly Olsen and Weizhen Tan contributed to this report.