The Diminishing Yield Premium in China's Onshore Bonds and Its Impact on Global Capital Flows

The global financial landscape has entered a pivotal phase as China's onshore bond yield premiums have eroded significantly against U.S. Treasuries. Over the past two years, the spread between China's 10-year government bonds and their U.S. counterparts widened to 164 basis points by August 2024—the highest since 2007—before narrowing sharply in 2025. This divergence, driven by divergent monetary policies, has reshaped capital flows and forced investors to reassess their exposure to emerging markets.

The Yield Gap and Monetary Divergence

China's aggressive monetary easing, including a 20-basis-point cut to its one-year medium-term lending facility rate in late 2024 and a 50-basis-point reduction in the reserve requirement ratio in May 2025, has kept domestic yields low. Meanwhile, the U.S. Federal Reserve's prolonged tightening cycle, aimed at curbing inflation, has pushed U.S. Treasury yields higher. This created a stark yield premium for Chinese bonds in 2023–2024, attracting foreign capital. However, the tide has turned. By 2025, foreign investor holdings of China's onshore bonds declined, as capital flocked to U.S. Treasuries, which offered higher returns amid expectations of Fed rate cuts.

The People's Bank of China (PBOC) has also played a critical role in this shift. Its rate cuts and liquidity injections, such as reverse repo operations, have suppressed domestic yields while managing the yuan's depreciation. The yuan's 5.5% decline against the dollar since early 2024 further eroded the attractiveness of yuan-denominated assets for foreign investors, who now demand higher compensation for currency risk.

Erosion of the Dollar-Yuan Swap Strategy

The dollar-yuan swap rate, a key tool for hedging currency risk, has undergone a dramatic transformation. In 2024, 12-month swap points narrowed by 25% from December 2024 levels, reflecting a shift in Chinese state banks from borrowing to lending dollars in offshore markets. This reversal—from actively seeking dollar liquidity to offering short-term U.S. dollar positions—signals growing confidence in the yuan's stability and a managed float strategy by the PBOC.

The narrowing swap premium is also tied to converging interest rate expectations. With the Fed anticipated to cut rates in late 2024 and China's economic data showing unexpected resilience, the yield differential between the two currencies has compressed. Citigroup forecasts that 12-month swap points could rise to -1,500 pips by mid-2025, a level last seen in early 2023, contingent on the timing of U.S. rate cuts.

Capital Flight and Asset Reallocation in Emerging Markets

The erosion of the dollar-yuan swap strategy has redirected foreign capital flows to other emerging markets. Chinese state banks' accumulation of $47 billion in net foreign assets in June 2025—a continuation of a $70 billion Q2 inflow—has created a surplus of liquidity that is no longer being funneled into dollar-yuan swaps. Instead, this capital is being channeled into higher-yielding assets in markets like Southeast Asia, India, and Brazil, where growth prospects and tighter fiscal policies have improved investor sentiment.

For example, India's bond yields, which rose to 7.5% in 2025 amid a strong fiscal consolidation, have attracted inflows from investors previously focused on China. Similarly, Brazil's real has appreciated against the dollar, supported by higher commodity prices and a more hawkish central bank. These shifts reflect a broader reallocation of capital away from China's onshore bonds, where yield premiums have collapsed, and into markets offering better risk-adjusted returns.

Investment Implications and Strategic Adjustments

For investors, the diminishing yield premium in China's onshore bonds signals a recalibration of emerging market strategies. The once-robust dollar-yuan swap strategy, which allowed foreign investors to hedge currency risk while accessing China's bond market, is no longer as effective. This necessitates a reevaluation of exposure to yuan-denominated assets and a closer focus on alternative emerging markets.

1. Diversification Beyond China: Investors should diversify emerging market allocations to include high-yield markets like India, Indonesia, and Nigeria, where growth fundamentals are strengthening. These markets offer higher yields and less currency risk compared to China's onshore bonds.
2. Hedging Revisited: With dollar-yuan swap spreads narrowing, hedging costs have decreased. However, the PBOC's managed float strategy introduces uncertainty, making it prudent to hedge only when the yuan's trajectory aligns with broader macroeconomic trends.
3. Sector Rotation: Capital is increasingly flowing into sectors like technology and infrastructure in emerging markets. For instance, India's digital infrastructure and Brazil's renewable energy projects are attracting greenfield investments.

Conclusion

The erosion of China's onshore bond yield premium and the shifting dynamics of dollar-yuan swaps mark a structural change in global capital flows. While the yuan's managed float and PBOC interventions have stabilized its value, they have also reduced its appeal for foreign investors seeking yield. As capital reallocates to other emerging markets, investors must adapt by diversifying portfolios, reassessing hedging strategies, and prioritizing sectors with growth potential. In this evolving landscape, agility and a nuanced understanding of regional dynamics will be key to capturing returns in the post-dollar-yuan swap era.