Illustration: Peter C. Espina/GT

It has been a year since China's central bank reformed the calculation method of the yuan central parity rate, it is now based on the previous day's closing rate on the inter-bank foreign exchange market. Over the past year, the yuan exchange rate has gradually stabilized following persistent depreciation.

The ultimate goal of both the exchange rate reform and China's bid for the yuan's inclusion in the IMF's Special Drawing Rights (SDR) basket is making yuan assets recognized internationally. Over the last year, the yuan's exchange rate formation mechanism has been made more transparent and predictable. Meanwhile, return on yuan assets remains relatively high, convertibility of the yuan has been enhanced and the yuan is expected to join the SDR this October. It is because of this progress that international investors are more inclined to hedge assets such as yuan-denominated treasury bonds and yuan-denominated policy financial bonds.

Overseas institutions have shown their increasing interest in yuan assets in a number of ways.

Foreign institutional investors have boosted their holdings of yuan-denominated treasury bonds, which have become a major tool for investors to hedge exchange risks. By the end of July, the total of yuan-denominated treasury bonds held by foreign investors hit a historical high of 321.87 billion yuan ($48.53 billion).

Foreign institutional investors have also increased holdings in yuan-denominated policy financial bonds. At the end of July, the total amount of bonds issued to foreign investors by three Chinese policy banks was 216.2 billion yuan, up nearly 10 percent from February.

International investors have also increased their positions in Chinese stock markets. Given swings in the markets over the past year, foreign investors have been cautious about investing in China's markets. However, as the markets have stabilized, foreign investment in Chinese stocks have gone up. By the end of June, international holdings reached 601.2 billion yuan, up 23.3 percent from totals at the end of January.

Finally, offshore yuan-denominated bonds have become increasingly popular. By the end of May, the Ministry of Finance (MOF) issued 3 billion yuan worth of three-year government bonds in London, with a coupon rate of 3.28 percent. The bond was more than twice oversubscribed due to high demand. Similarly, the 14 billion yuan of yuan-denominated government bonds issued by the MOF in Hong Kong was 2.5 times oversubscribed by the end of June.

There are three factors that have contributed to this increasing appeal in yuan assets overseas.

First, while a pessimistic outlook is still held by some domestic and international investors, the gradual transparency and predictability following the change in the rate formation mechanism indicates that there is no basis for continuous depreciation. The yuan weakened 2.4 percent against the dollar since the start of the year and the CFETS RMB Index was down around 5 percent, but in the last two months the yuan exchange rate has remained stable at around 6.7 to the dollar. It is worth noting that the spread between offshore yuan non-deliverable forward rate and onshore yuan spot rate that reflects market expectations has remained in the range of 150-200 basis points since the beginning of the year, compared with 400 basis points in December 2015.

Second, the yield on yuan-denominated treasury bonds is considerably higher than on treasury bonds issued by most developed economies. Since the beginning of the year, central banks in some European countries, such as in Sweden, Denmark and Switzerland, have announced negative interest rates, which have sunk the yields on those country's bonds. The 10-year treasury bonds issued by Japan and Germany have also entered into negative interest rate territory. The yield on bonds issued by the US is positive, but the spread between yield of bonds issued by China and the US is widening, with the yield gap on 10-year treasury bonds expanding to 100-150 basis points. Yuan-denominated government bonds will hold greater appeal to investors seeking to hedge against exchange risks.

Lastly, the yuan's impending inclusion into SDR will further boost the currency's appeal. The yuan's inclusion into the IMF's basket of reserve currencies becomes effective on October 1, 2016 with the yuan holding a 10.9 percent weighting in the basket, higher than the yen's 8.33 percent and sterling's 8.09 percent. Following this, yuan assets will surely become part of foreign currency reserve assets held by central banks around the world.

At the same time, the yuan has become more convertible, due to a series of decentralization reforms and policies to further liberalize the capital account, which ensures a freer cross-border flow of the yuan. Additionally, the yuan's high sovereign credit rating, China's abundant foreign currency reserve and the country's resilient economy among G20 countries are all key reasons that will spur international investors to seek and hold yuan assets in the long term.

Essentially, from the medium- and long-term points of view, it will become mainstream for international investors, especially overseas central banks, to boost their holdings of yuan government bonds as hedge assets following the yuan's inclusion into SDR. The yuan is expected to become a major international currency alongside the US dollar, euro and Japanese yen.

The author is the director of the Center for Trade Finance at Suning Institute of Finance. [email protected]