JUST as China’s US$10 trillion bond and equity markets appear to be on the cusp of joining global indexes, investors who long sought free access to these assets have started to worry that any returns would be hit by a weakening yuan.

    Many were disappointed by MSCI Inc.’s decision last week to keep China’s mainland listed A shares off its emerging market indexes on the grounds that China needed to make its markets more easily accessible to foreign investors.

    But market watchers said the decision, made after months of consultations with investors, at least partly reflected fund managers’ unease about allocating more to yuan-denominated assets. Currently, MSCI indexes include only Chinese stocks listed offshore that are freely traded.

    China’s mainland stocks will almost certainly be added to equity indexes in the coming years, if not months, as will the country’s US$7 trillion government bond market, the world’s third biggest.

    That should bring more capital inflows, especially as foreign holdings of local shares and bonds currently amount to just US$180 billion, JPMorgan calculates.

    But the timing is tricky.

    An economy growing at its slowest pace in 25 years, falling exports and potential U.S. interest rate rises are seen portending yuan weakness. Memories are still fresh of last August’s devaluation, when the yuan fell 2.7 percent against the U.S. dollar in one week.

    “There is pent-up demand for exposure to China, but we are probably in a period when the world is happy not to hold too much of it,” said Kieran Curtis, a bond fund manager at Standard Life Investments.

    “You get a pretty decent [bond] yield but people will be reluctant to pile in because of expectations of currency depreciation.”

    Recent yuan moves give credence to such fears.

    Authorities have recently been fixing the official exchange rate at steadily weaker levels, pushing it to five-year lows. That weakness and a surge in outbound investment could also fuel a resumption of last year’s huge capital outflows.

    The yuan has fallen 8 percent against the dollar since the end of 2013, ceding a quarter of its appreciation since 2005. But against its trading partners’ currencies it has fallen 4.3 percent this year, suffering more trade-weighted depreciation than any emerging currency other than the Mexican peso.

    Keen to boost the international profile of its markets and currency, China has rushed to make the changes that index providers require, relaxing quota-based investment programs and clamping down on arbitrary share suspensions.

    Bond investors were told last month they would be able to remit money more freely, a move seen as potentially enabling entry to major debt indexes and bringing in at least US$155 billion, according to JPMorgan estimates.

    JPMorgan has already put China on a watchlist for its GBI-EM emerging bond index.

    China’s government pays 3 percent on its 10-year bonds, far higher than any other country whose currency is in the International Monetary Fund’s SDR basket.

    But while this is high in the global context, it may seem paltry to emerging debt specialists who earn more than 6 percent on the GBI-EM index on average.

    “At this juncture, I don’t think China will attract material interest...it will be the lowest yielding market in the [GBI-EM] index. Plus the tail risk that they could devalue,” said Naveen Kunam, portfolio manager at Allianz Global Investors.

    Indeed, non-deliverable forwards, derivatives used by investors to lock in future exchange rates, price the yuan at 6.8 per dollar in a year’s time versus the spot rate of 6.6. (SD-Agencies)