By Shen Hong 

SHANGHAI--Foreign investment in Chinese government bonds is surging, creating risks for both investors and Beijing, which has long kept a tight hold on this $2 trillion market.

Borrowing costs in the world's second-largest economy are determined in part by China's equivalent of the Treasury market. This is dominated by local banks, insurers and brokerages, most state-owned. In the past the central bank has injected short-term funds to prop up the wider market, or quietly told banks to buy or sell--so-called window guidance.

Now Beijing, facing capital outflows and a shrinking trade surplus, is opening the door wider to foreign institutions such as central banks and university endowment funds. Since 2016, the yuan has been part of the International Monetary Fund's elite club of reserve currencies, while Beijing has expanded market access, first for investors with trading accounts in mainland China and later in Hong Kong. Its government debt is poised to join major world bond indexes.

Global investors held a record 1.08 trillion yuan ($155.63 billion), or 8.1%, of China's domestic government bonds in October, up from 2.7% in February 2016, when access was first widened. That is similar to Beijing's 7.6% share of U.S. Treasurys as of August.

The new arrivals face some unfamiliar risks. China's leaders are inclined to tamp down instability, and have balked at giving market forces free rein in the equity markets. Global investors, used to evaluating debt based on the likes of supply and demand, creditworthiness and economic fundamentals, might find it harder to predict how Chinese bonds will react to developments such as faster inflation or rising global borrowing costs.

From Beijing's perspective, the influx should initially help keep interest rates low, stimulating the slowing economy. But over time the presence of investors with plenty of alternative places to put their cash--in contrast to captive domestic institutions--could push yields up. A rush for the exits could create a situation much like a typical emerging-markets crisis.

"A sudden retreat of foreign investors would be a medium-term concern for Beijing because lots of these inflows are pro-cyclical, meaning when the economy is in a downturn, foreign investors tend to pull out of a country," said Logan Wright, a Hong Kong-based analyst at research firm Rhodium Group.

These foreign institutions have largely focused on central-government debt-- safer than that issued by local governments or Chinese companies, and tax-free. Through Chinese banks still own roughly two-thirds of this market, foreigners have accounted for 44% of net buying this year.

"What really matters is these marginal purchases," said Mr. Wright. On current trends, his firm estimates foreign ownership could come close to 25% in four or five years, not far off levels in other Asian emerging markets such as Indonesia and Malaysia.

The newcomers have already made their presence felt. As they snapped up safer, shorter-dated debt this year, prices rose. Yields, which move in the opposite direction of prices, fell more sharply than those on longer-term bonds--a "yield-curve steepening." The yield gap between 10-year and three-year bonds has widened this year to 0.43 percentage point from 0.10 percentage point.

The steepening "shows foreign investors are already a formidable force in this market," said Peter Ru, chief investment officer of China fixed income at Neuberger Berman. Other investors and traders also cited foreign buying.

In another episode, the Russian central bank caused a stir in late April when it unexpectedly bought a large chunk of a single, five-year government bond, said a person with direct knowledge of the matter. The bond's yield fell sharply even as yields on similar bonds were rising.

"It might have been just a normal asset allocation by that central bank, but it definitely sent ripples across the market," said Meng Huan, a bond-fund manager at Shanghai Yunhan Asset Management Co.

A few weeks later, China's Ministry of Finance, using a new intervention mechanism, sold three billion yuan of the same bond, pushing prices down and yields up. The anomaly disappeared. Neither institution responded to requests for comment.

Such reluctance by Beijing to cede control is a potential turnoff for global money managers, as are an increasingly tough economic climate and a lack of policy stability.

"It's been a tough year to trade in this market because policies have swung back and forth between cutting the country's debt pile and supporting economic growth," said Mr. Ru at Neuberger Berman.

Local traders and investors say they welcome foreign investors because they will bring more sophistication and diverse investment styles into a once uniform market. More activity could also mean higher profits for trading desks.

"They also possess a more global perspective and that's why we are paying a lot more attention to what they do in the market nowadays," said Ms. Meng.

Write to Shen Hong at hong.shen@wsj.com

(END) Dow Jones Newswires

November 19, 2018 08:14 ET (13:14 GMT)

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