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Emerging Markets

Chinese bonds: evolving in leaps and bounds

Fixed Income Monthly
May 2017

Cary Yeung, Head of Greater China Debt

There's no doubt Chinese local currency bonds will become a bigger feature of global portfolios.

Why does the renminbi's inclusion in the IMF's Special Drawing Rights (SDR) currency basket transform Chinese local bonds into a strategic investment? 

CY: The IMF's move is not only an important symbolic step for China. It also has the potential to boost inflows into the country's local capital market. Although the renminbi has an initial weighting of 10.92 per cent in the SDR, the world’s central banks only have around 1 per cent of their reserves in the currency. That gap is sure to close. Our calculations show that just a 1 per cent shift in global reserves into renminbi-denominated assets would generate USD77 billion of net inflows into the Chinese onshore bond market. That compares with the USD180 billion of offshore local currency bonds currently held by foreign investors, which is just 2 per cent of the total market. In the long term, we expect the renminbi to evolve into a fully-fledged reserve currency, with its share of international central bank reserves rising to around 20-30 per cent over the next decade.1

How rapidly is the local debt market opening up to foreign investors?

potential inflows into RMB bond market
RMB numbers

Source: Pictet Asset Management, Goldman Sachs

CY: Chinese authorities have been implementing several policies in a bid to attract foreign investors and boost flows into the onshore local currency bond market. The China Interbank Bond Market scheme shortened and simplified the application process for institutional investors in February 2016, while in March 2017 the government began allowing overseas investors to hedge their foreign exchange exposure in a cheaper and more liquid onshore derivatives market. Beijing also plans to launch a "Bond Connect" programme with Hong Kong to link onshore and offshore debt markets, which would further improve access for overseas investors.

These measures could help China's case for inclusion in the major global bond indices – another important step in the market's evolution into a strategic asset class. Citigroup has already decided to add Chinese domestic bonds to its three sub-indices, potentially paving way for their inclusion in its main World Government Bond Index, which has a market capitlisation of nearly USD20 trillion. If other benchmark providers, such as JP Morgan and Barclays, follow suit, it could generate as much as USD250 billion of fresh inflows (see chart).2

Why should fixed income investors hold Chinese onshore debt in their global bond portfolio?

CY: Fixed income investors are still underexposed to China’s onshore bond market, which is the world’s third largest with USD9.4 trillion of outstanding debt. An emerging market that is gaining depth and opening up rapidly, Chinese onshore local currency debt has the potential to boost a portfolio's income as well as diversify its sources of risk and return. Chinese local currency bonds yields are attractive while the asset class exhibits a low correlation with other fixed income markets. Being exposed to the renminbi - which we believe will appreciate over the long run as it continues its march towards internationalisation - offers an additional source of return in the shape of currency gains. 

Yields on five-year Chinese onshore government bonds stand at around 3.3 per cent, compared with 1.8 per cent for US Treasuries and negative rates for government bonds of Japan and Germany of the same maturity.3 Correlations between Chinese onshore bonds and other asset classes, meanwhile,  are also low (see chart) partly because China's economic cycle is not in sync with that of developed economies.

rENMINBI onshore debt can diversify a multi-asset portfolio 

Correlations between Chinese onshore debt and other asset classes

correlation
All indices are total return and in USD. Based on monthly data from 31.10.2008 - 31.08.2016. Source: Chinabond, JP Morgan, HSBC, Bloomberg. 

After last year’s dramatic sell-off in the renminbi, financial conditions in China have become more settled. How do you view the economic and investment landscape? 

CY: Economic data has stabilised and growth momentum has picked up, helping ease concerns about a possible hard landing and reinforcing our view that the world’s second largest economy will remain in good health.

Concerns over capital outflows have also faded after the People’s Bank of China (PBoC) implemented stricter capital controls and tighter monetary policy. The PBOC raised interest rates by 10 basis points twice in the first quarter of 2017 on both its medium-term lending facility and its open market operation reverse repurchase (repo) agreements. As a result, short-term money market rates have also risen. Moreover, the authorities tightened scrutiny on outbound M&A, restricting approvals on deals involving the purchase of assets that match core business lines in China.

Risks do remain, but I think the worst of capital flight is behind us and improving economic data, tighter monetary policies and a strong trade surplus will help stabilise the currency. In February, China’s capital flows turned positive for the first time since June 2016, with inflows of USD13.8 billion4. With the US Federal Reserve set to raise interest rates again later this year, the PBOC is also likely to tighten monetary policy further.

Another positive is that China and the US have so far adopted a conciliatory tone in their diplomatic relationship. US President Donald Trump has yet to follow through on his campaign threats to impose heavy tariffs on Chinese imports or to label Beijing a currency manipulator. Optimism is growing that the two economic powerhouses could find common ground and reach some kind of trade deal. What’s more, during his recent meeting with Chinese President Xi Jinping in Florida, Trump said that the US government would spend another 100 days reconsidering its trade policies with Beijing. If the two countries can reach a compromise, it should allow China to benefit from improving global external demand; global exports are already growing at an above-average rate of 12 per cent a year in nominal terms.

How do you assess Beijing’s efforts to contain a rapid build-up in Chinese corporate debt?

CY: The National People’s Congress made tackling corporate debt a top policy priority this year. Alongside tightening monetary policy, the authorities are allowing local asset management companies to buy non-performing loans from banks to contain risks in the financial sector. The government is also starting to allow selective defaults among unprofitable companies in sectors with excess capacity, such as coal, mining and ship building. All of this deleveraging points to a healthier and higher quality onshore bond market as the government weeds out some zombie enterprises at a controlled pace. The default rate is expected to rise from a low base of 0.3 per cent but the risk of systemic crisis is pretty low, in my view.

How is your portfolio positioned and why?

CY: We continue to overweight debt issued by high-quality state-owned enterprises in strategically important industries, such as electricity, power plants, railways and telecoms. The average internal rating of the portfolio stands at A, according to our own measure using international rating standards. Our portfolio has a shorter duration than the benchmark as we expect yields to rise in the short term. We also have an off-benchmark position in offshore USD-denominated debt from Chinese issuers, which trade at higher yields.

China’s green bond sector, which is still in its infancy, is also worth watching as Beijing mobilises private capital to tackle pollution and other environmental challenges. The country is already the world’s biggest green bond market, having issued RMB238 billion (USD36.2 billion) of such securities in 2016, which accounts for 2 per cent of Chinese bonds.