If China found MSCI a tough nut to crack, compilers of global bond indexes may prove even harder to please.
While policy makers have allowed global funds greater access to the $6.4tn interbank debt market, investors flag restrictions such as a ban on onshore foreign-exchange trading, unclear tax rules and curbs on bringing home profits. MSCI cited a repatriation limit when it said last week that it wouldn’t include Chinese stocks in its benchmarks. Citigroup, which in March welcomed China’s opening of its bond market, said last week that it is seeking client feedback that can be used in any potential review.
“Bond investors are going to be much, much more driven by technicalities, or issues like repatriation, settlement and taxes,” said Luke Spajic, Singapore-based head of portfolio management for emerging Asia at Pacific Investment Management Co, which oversees about $1.5tn worldwide. “Scrapping quota restrictions is all about entry, which gets investors excited. However, exit is equally important and arguably a greater concern in times of market stress.”
The MSCI rejection sounds a warning for China as policy makers look to attract funds to support a fragile economy amid record bond issuance, a declining yuan and an estimated $1tn of capital outflows in the past year. The nation will push for the inclusion of domestic notes in global measures such as those compiled by Citigroup, JPMorgan Chase & Co and Barclays, People’s Bank of China Deputy Governor Pan Gongsheng said this month.
The stakes are high: HSBC Holdings estimates that inclusion in major bond indexes could help draw as much as $150bn to Chinese government debt, compared with a probable $30bn for MSCI equity gauge inclusion. 
Even though the requirements of bond investors - and index compilers - may be harder to satisfy, China is closer to finding a solution for access to its debt market than it is for stocks, Spajic said. He earlier estimated that next year or 2018 would be a realistic target for Chinese bonds to enter global measures.
The PBoC said in February that all medium- to long-term foreign institutional investors can access the interbank bond market without quotas. Last month, the State Administration of Foreign Exchange released currency exchange rules for the program, followed by a June 14 central bank statement that the first group of money managers had registered.
While the SAFE regulations increase the chances for China to be included in the indexes, the steps are not without limitations, said Chen Yang, Hong Kong-based rates strategist at Bank of America Merrill Lynch. Procedures requiring the filing of tentative investment amounts first and currency trading is restricted, Chen wrote in a May 30 report.
“Chinese regulators should turn the market totally free, although I don’t expect or hope they will do so before they are ready,” said Woon Khien Chia, Singapore-based senior portfolio manager at Nikko Asset Management Asia, whose parent had ¥17.42tn ($167bn) of assets under management at the end of March. “The licensing, monitoring of inflows and limits on net foreign exchange in- and outflows still don’t give investors total freedom.”
Capital account convertibility is a prerequisite for President Xi Jinping’s efforts to turn the yuan into an international currency. Yet investors still face lengthy government reviews in many types of cross-border investments.
JPMorgan, in a June 16 e-mail, pointed to a March announcement that it had placed China’s onshore government bonds on review to be included in its emerging-market indexes. Barclays didn’t reply to an e-mailed request for comment, after saying in March that it was “monitoring the situation.”
Overseas entities held 680bn yuan of onshore debt at the end of March, 70% more than at the end of 2013, when the PBoC started to release the data. By comparison, foreign holdings of equities grew 66% to 571bn yuan. The yuan is set to officially join the International Monetary Fund’s Special Drawing Rights on October 1, bringing passive inflows as global reserve managers adjust their holdings. China’s one-year sovereign note yields 2.40%, 191 basis points more than its US counterpart. That compares with negative interest rates in Japan and Germany, and 1.37% in South Korea.
“The pressure on index compilers is that the yuan is going into the SDR,” said Nikko’s Chia. “This, in addition to low to negative rates among the rest of the SDR basket components, would compel global central banks to enter.”