-The phased inclusion of Chinese Government bonds over the next 20 months into the Barclays Global Aggregate Index could channel up to $2 trillion of funds into China’s onshore debt market, according to Moody’s and take China’s weighting in the index to just over 6%.
The current weighting in the Barclays Global Aggregate index is as follows:
*Asia = Japan 17% plus other 4%
-JP Morgan has also announced that it intends to include Chinese domestic bonds in its key global bond index and the FTSE Russell World Government Bond index is expected to confirm China’s inclusion in the coming months. Foreign holdings of onshore domestic bonds stood at $250 billion as at the end of January, which is a paltry 2% of the outstanding total.
-The Global Aggregate Index is tracked by an estimated $2.5 trillion of portfolio assets under management and a 6% weighting would therefore bring $150 billion to Chinese fixed income, following an expected $115 billion inflows to the A share market following China’s inclusion in the FTSE Emerging Index.
-Analysts have long argued China’s bond market, the world’s third largest, at $12.42 trillion, is simply too big to ignore. It is just shy of Japan’s $12.62 trillion, but still well below the US’s $40.72 trillion.
-In the past, restrictions have prevented many investors from tapping into Chinese bonds, but over the years it has made access easier for foreign investors and has recently added two key capabilities: delivery versus payment and block trades, which are common features in financial markets elsewhere. Beijing also clarified how it will tax foreign investor gains from Chinese bonds.
Pessimistic – Short Term Consensus view
-With most forecasters predicting a rather negative outlook for the Renminbi, domestic Chinese bonds should be avoided.
– This view appears to be supported by the growing likelihood of a current account deficit, either this year or next, slowing economic growth and the possibility that future capital market reforms might result in a repeat of the capital outflows that occurred between mid-2014 and early 2017.
Optimistic – Alternative longer-term view
-Chinese sovereign bonds carry an investment grade A+ rating, with yields above 3%, for maturities beyond five years and in the past have typically been uncorrelated to all other major asset classes.
-While China is known for producing and exporting products at a competitive price, it has historically undervalued its exchange rate in order to promote trade.
-Despite a rare current account deficit in the first quarter of 2018, a reaction to the prospect of a trade war with the US, the trade gap between the two countries rose surprisingly to a record $419.2 bn in 2018, up from the previous high of $375.5 bn in 2017.
– Any weakness in the US economic growth outlook is likely to have more of an impact on the trade gap than political rhetoric from Trump, which has probably delayed the threat of an imminent Chinese current account deficit.
-The next phase of economic growth is likely to be more domestically driven and accompanied with further capital market reforms.
-Morgan Stanley predicts $210 billion every year for the next decade, or six times the level of recent flows, driven by changing demographic trends, which will result in a growing, more liquid domestic bond market.
-A further positive factor that should be Renminbi supportive over time is the need for Central banks to diversify their reserves and be less reliant on the US Dollar, which currently comprises almost 58% of all balances held.
-Allocations to the Renminbi have steadily increased, albeit from very low levels, from 1.07% in Q4 2017 to 1.8% in Q4 2018, when its proportion exceeded the Australia dollar’s share for the first time.
-Goldman Sachs have suggested that its share in global reserves should rise towards 4% by the end of 2022, still relatively insignificant, but effectively doubling in the next three years.
-At the beginning of this year it raised the ceiling for the Qualified Foreign Institutional Investor program, from $150 billion to $300 billion, which was its first expansion since July 2013.
-This, together with the inclusion of domestic Chinese stocks and bonds into recognised global market indices is further recognition of China’s intention to liberalise its capital markets, which should encourage wider foreign ownership.
-The outlook for the Renminbi may not as bleak as most forecasters are suggesting and a move back towards 7.0 versus the US dollar should be avoided. A stable currency trading in a 6.5 to 6.7 range would appear more likely, with a longer term move below 6.5, supported by increased foreign flows and the symbolic significance of the Renminbi gaining the international credibility that the second largest global economy should command.
Broader Asian Bond markets
-The inclusion of Chinese Government bonds into recognised global bond indices is also likely to raise the profile of Asian regional bond markets to a wider audience.
-China and Asia are obviously closely aligned with a large proportion foreign direct investment (FDI) flows into China from its advanced Asian neighbours, particularly those that have net trade surpluses with China, such as South Korea.
-In the current low interest rate environment, with negative yields particularly evident in Europe, an exposure to Asian bond markets appears to be a sensible alternative.
-It is less volatile than investing in global emerging debt strategies and is supported by strong economic fundamentals, not just reliant on global trade, but supported by strong intra-Asian regional trade, which at just under 60% provides protection against an economic slowdown in either the US or Europe.
-Asian fixed income markets have fundamentally changed since the 1997-98 financial crisis, with more robust financial support mechanisms, stronger regulations and far greater regional co-operation.
-Over the last 5 years Asian debt markets have produced annualised returns in the region of 4%, with a low annualised volatility in the region of 3%, which is a lower annualised volatility than US Credit and almost half the volatility of the JP Morgan Global Emerging Market Bond (EMBI) index.
Written by Tony Wood.