23 Aug 2016
Investors have been piling into government bonds, driving yields continually lower as concerns about lacklustre global growth, benign inflation levels and overall economic uncertainty dominate investor sentiment.
"A world of ultra-low yields is likely to persist for some time and this will see more investors turning their attention to China."
Daniel Everett, Global Head of RMB, Strategy & Execution, AN
Once considered a yield asset, bonds are now being held for their security and, surprisingly, their potential to produce a capital gain. That’s right: investors holding negative yielding bonds may expect current negative rates to fall even further, generating a capital return to offset the negative yield.
So what does all this mean for China?
To begin with, China’s sovereign yields are positive. The 5 year and 10 year yields are approximately 2.50 per cent and 2.70 per cent respectively and present a significant pick-up over US, European and Japanese bonds.
Also, China has the third largest bond market in the world (behind the United States and Japan) which at the end of June this year was valued at around US$8.5 trillion.
Maybe this size sounds reasonable given China is the second largest economy in the world with $US11 trillion in GDP. However its bond market represented just over 60 per cent of GDP as at June 2015 and is now closer to 75 per cent as at June 2016.
The United States, by comparison, has a bond market exceeding $US35 trillion in value which represents over 200 per cent of GDP. The potential opportunity as China plays catch up should be obvious.
China’s bond market has been slow to develop due to strong cross-border capital controls which restricted foreign investment and issuance. Easy access to onshore bank loan financing for local corporates and financial institutions has also reduced the need for bond issuance.
Capital account controls via complex quota schemes have meant foreign investors own only around $US115 billion (or less than 2 per cent) of the $US8.5 trillion Chinese bonds on issue, while the number of onshore bonds issued by foreigners could be counted on one hand.
Despite recent falls, the foreign investment trend has been growing, but it has been slow and is still small.
It is estimated bonds represent approximately 20 per cent of debt financing in China with the remaining 80 per cent supplied by traditional bank or ‘shadow bank’ loans.
In more developed economies, the bond markets play a significantly larger role in debt financing; in the US for example, bonds comprise about 70 per cent of debt finance compared with China’s 20 per cent.
During 2015, China’s bond market grew by more than $US2 trillion (over 35 per cent) primarily driven by local government issuance following the debt swap program (high cost bank loans refinanced into cheaper bonds) as well as non-financial corporate bond issuance.
The shift from a ‘loans market’ to a ‘bonds market’ is starting although true private sector investor diversification and participation is still weak.
On the face of it, economic and financial factors point to the China bond market developing significantly, but are the necessary reform measures and stimulants in place to allow this to happen?
At a high level, the answer is yes. A number of game changers have emerged recently which look set to propel the Chinese bond market to the forefront of thinking for global investors in the coming years.
In November 2015, the International Monetary Fund (IMF) announced the renminbi (RMB) will form part of its Special Drawing Rights basket from October 2016. This is a real credibility boost for the RMB and will, over time, see more reserves allocated to RMB.
In fact, Standard & Poor’s recently estimated the RMB will move from its current share of official foreign currency reserves of less than 1 per cent to 11 per cent in due course. This could see close to $US1 trillion allocated to RMB denominated assets like Chinese bonds over time.
The People’s Bank of China (PBoC) has now made it significantly easier for global investors to access China’s interbank bond market where over 90 per cent of bonds are issued and traded.
Measures introduced in July 2015 and further rules released in February 2016 allow preferential bond market access to a very broad range of global investors.
Under the regulations, sovereign wealth funds, central banks, commercial banks, insurance companies, asset managers, pension funds and securities companies can now invest without a quota or onerous approval process.
These measures have the added policy benefit of providing capital inflows into China which may help stabilise the currency amid a period of increasing capital outflows and a weaker RMB.
It is looking increasingly likely Chinese bonds will begin to find their way into global benchmark indices, for example the JP Morgan Government Bond Index – Emerging Markets (JBI-EM) and the Citibank World Government Bond Index. Inclusion in indices would certainly see flows into Chinese bonds.
Issuance by foreign corporates and financial institutions in China will grow as the so-called ‘Panda bond’ market re-establishes itself and China develops a more attractive issuance framework for offshore borrowers.
A diverse issuer base, as well as a diverse investor base, are key features of a well-developed bond market and will aid liquidity as well as market capitalisation.
Even Chinese government bond issuance could grow to satisfy future demand. According to consultants McKinsey & Co, Chinese government debt was approximately 55 per cent of GDP in 2014, compared with 89 per cent in the US, so there certainly appears scope for growth.
It won’t all be smooth sailing.
Concern about the potential for further RMB currency weakness against the USD has the potential to make Chinese bonds a less attractive investment.
In addition, even if China receives the maximum weight in the JBI-EM of 10 per cent, investors may run an underweight position given China’s lower relative yield compared to other emerging markets as well as the uncertain outlook for the RMB.
However, China bonds do present a new and significant diversification benefit to a global fixed income portfolio from a yield, currency and risk perspective. In addition, yield-starved investors could see Chinese sovereign bonds as an attractive yield alternative even on a risk-adjusted basis.
Market volatility has also been more prevalent in Chinese markets over the past year as ongoing reforms and government intervention in the foreign exchange and equity markets create some ongoing concern about future developments and policy clarity and commitment.
Ongoing default risk, particularly in the corporate credit market in sectors with over capacity, also presents challenges. Chinese authorities are allowing more defaults to occur, rather than propping up unsustainable businesses; this is a positive move.
Similarly, current credit rating processes are deficient leading to homogenous ratings seemingly devoid of rigorous risk assessment and global consistency.
Further development is also required in the onshore derivatives market to ensure a broader and deeper suite of currency and interest rate hedging products for both issuers and investors. The foundations are there but they need to be scaled.
Investors are likely to approach their investment in Chinese bonds with caution and on a gradual basis.
There are, however, enough economic, financial and regulatory factors pushing the case for Chinese bonds to become a significantly larger share of global bond portfolios. The sheer scale of the medium term opportunity as more foreign issuers and investors arrive should not, therefore, be underestimated. Reform is happening fast and in the future, China will rival the US for the largest bond market in the world; it is just a matter of time.
In the meantime, a world of ultra-low yields is likely to persist for some time and this will see more investors turning their attention to China.
Daniel Everettis Global Head of RMB, Strategy & Execution, ANZ
ANZ, in partnership with the Financial Times will be hosting the next instalment of the FT-ANZ RMB Growth Strategy Series in London on September 22. For further information click HERE.
The views and opinions expressed in this communication are those of the author and may not necessarily state or reflect those of ANZ.
23 Aug 2016
19 Aug 2016
15 Aug 2016