-- Caused by distorted US dollar’s cost as a result of Fed’s endless asset purchase, the long divergence of real interest rates of US and China seems to have constantly created arbitrage opportunities involved with China's onshore bonds.
-- While the uncertainty of tapering makes it hard for the forward US dollar to be priced in these bonds, the US dollar’s appreciation caused by Fed’s tapering could sweep all earnings of arbitrage.
-- There is also a possibility that inflation expectation in China is being underestimated and the current premium will thus not be able to offset the resulting depreciation of RMB.
-- All risks above undertaken by China's onshore bond’s buyers are also risks for offshore bond’s issuers; The premium offered by China's offshore HY bonds issuers, if still as high as in normal times, may have to be justified by higher default risks than normal.
-- Both onshore and offshore bonds’ buyers have full-award premiums for default risks but not for the uncertainty of CB’s policies and inflation.
China’s excellent performance in handling the Covid-19 pandemic is a huge plus for narrowing the risk premium of China assets required by foreign investors undertaking systematic risks related to the relatively isolated economic and social system.
Another reason that can help explain why China assets have been increasingly attractive is the narrowing premium for their liquidity risks as a result of China’s opening financial market.
It is always least possible to underestimate default risks of the oversea debt market for both onshore and offshore buyers.
An onshore bond’s higher premium for being exposed to declining purchasing power of the country's currency does not usually make it an arbitrage opportunity since it is reasonable to expect a depreciation in this currency given a higher inflation. However, our model indicates that one of the unexpected risks involved in China's onshore bond is that the premium currently offered for expected inflation may not be sufficient.
In fact, the real risk is from what creates arbitrage opportunities - the difference in the people’s desire in two countries to spend money instead of saving it as expressed in the difference in real interest rates in two countries. Due to the Fed's large asset purchase, the divergence in real interest rates of the USA and China seems not to be narrowing with soaring demand for borrowing to capture arbitrage opportunities in China's onshore bonds. However, it is reasonable to expect an appreciation in US currency given the Fed's tapering. Our model indicates the premium, currently offered by China’s onshore bonds, for risks in changes of CB’s policies may not be sufficient.
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