The opening up of China’s bond market to foreign investors poses a threat to indebted economies that many observers don’t appreciate, argued Andy Seaman, chief investment officer at UK fund house Stratton Street.

Greater liberalisation will trigger a huge flood of funds into China’s bond market, he forecast. “That capital must have to be allocated from somewhere else, and countries most vulnerable under those circumstances are the most indebted."

China operates two schemes that allow foreign investors access to its exchange bond and interbank markets. In its 2013 annual report, China’s central bank said it would remove quotas when conditions permit.

Stratton Street uses net foreign assets – the value of assets that a country owns abroad, minus the value of domestic assets owned by foreigners – expressed as a percent of GDP to gauge wealth.

Some of the wealthiest (least indebted) economies are Hong Kong (276%), Qatar (263%) and Singapore (251%), while the poorest comprise Iceland (-166%), Greece (-147%), Bulgaria (-142%) and Portugal (-141%).

Now that some countries are deleveraging following the global financial crisis, capital is flowing back to where it came from – from debtors to creditors, noted Seaman. If that adjustment process occurs rapidly, it would damage the economies of indebted countries, he warned.

However, quantitative easing put the brakes on the process, he noted, because it increased the amount of capital available – enabling indebted countries to borrow excessively.

Turkey is a case in point, Seaman said. It has a current account deficit of 8% of GDP, and is projected to have a cumulative current account deficit of over 40% in the next five years. “It will have to finance that from somewhere, and with QE providing a cushion, that’s relatively easy. Once it’s removed, it gets more difficult.”

As monetary policy in the US becomes tighter, the deleveraging process will accelerate, with capital being sucked out of the system and rates rising.

At the same time, Seaman forecast that China will open its debt market, triggering massive inflows. The mainland bond market is the world’s third largest at $4.8 trillion, he noted, adding that foreigners own 60% of US debt, and in the UK that figure is 30%.

“We estimate if foreigners take 45% of that bond market, demand will be $2.2 trillion,” he said. As of March, foreign investors held just $62 billion of onshore Chinese bonds, according to Bloomberg. “Whether that process takes five or 10 years, that’s an enormous amount of capital that’s going to flow into China."

The yield on two-year Chinese government bonds was 3.2% yesterday. The country’s sovereign rating is A+ from Fitch and AA- from S&P.

“That’s going to be very attractive,” said Seaman. “Look at Spain with a five-year yield of under 1%. Why would you lend to Spain on such low yields when you can lend to a more credit worthy country which yields a lot more?”