China's first domestic issue of US dollar bonds by a financial institution turned out to be more successful than some analysts had predicted, brightening the prospects for a domestic dollar bond market.

Despite worries of over pricing dampening investor enthusiasm, the US$500 million five-year issue by the policy lender China Development Bank (CDB) was quickly bought up by domestic financial institutions on September 19.

"As the first of its kind, I should say it was very successful," said a senior CDB manager, who asked not to be named. "It was not only fully subscribed, the borrowing costs turned out to be lower than (if we borrowed) overseas."

The interest rate came out at 3.65 per cent. That is five to 10 basis points lower than the price it would have to offer when it borrows in the international markets, the manager said.

The issuer's domestic credit rating is equal to that of the Chinese Government, but China's sovereignty debt credit rating is only BBB on the international market. That typically translates into a 50 basis points risk premium over equivalent US Treasury bonds.

The issue could have been more successful if it were available to more than just domestic financial institutions, the manager said. "Businesses and individual investors were the most interested, but were not allowed to subscribe," he said.

Eligible investors were split over the market prospects before the issue date. Most noticeably, two major Chinese banks - the Industrial and Commercial Bank of China and the China Construction Bank - did not apply for underwriter status.

For them, the CDB's deal appeared less appealing than a full spectrum of alternatives on the international market, which such major banks have easy access to, unlike their smaller counterparts. As potential issuers, trying to raise cheaper funds to replace costlier foreign debts, they were presumably reluctant to offer high returns.

But the potential buying power was strong. China's forex reserves soared by 42 per cent on a year-on-year basis to US$346.5 billion at the end of June, while forex deposits at financial institutions rose by 2.7 per cent to US$150 billion at the end of last month.

That situation, noted the CDB manager, had facilitated the government's decision to approve his bank's bond plan.

The government issued a circular last year that encourages domestic enterprises to raise dollar funds domestically to restructure their costlier foreign borrowing.

And the CDB's bond issue is expected to blaze the trail for a domestic US dollar-denominated bond market that will open an important investment channel for the mounting dollar holdings with both Chinese businesses and individuals.

"From an investors' perspective, the investment value of dollar bonds is just undeniable," said Ou Zhenbiao, a forex trader at the Bank of China.

The CDB's issue boasts the highest domestic credit rating, is tradable on the secondary market, and its 3.65 per cent return is way higher than the 0.6875 per cent interest rate Chinese banks pay on two-year dollar deposits, he explained.

The experience of the bank's issue will provide policymakers a valuable reference point as they formulate rules on future domestic dollar-denominated bond issues, which are also widely believed to play an important role in alleviating the upward pressure on the exchange rate of the local currency, known as the renminbi or yuan.

Excess dollars in the interbank market, which largely resulted from trade surpluses, have been forcing the hands of China's monetary policymakers. Efforts to absorb such excesses to keep the yuan's exchange rate within its range have led to unwanted rises in the country's money supply and fuelled inflationary fears.

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