Foreign investors and central banks will continue increasing their allocation to Chinese government bonds. They offer a relatively high yield and are a safe investment, says Freddy Wong, head of Fixed Income Asia-Pacific at Invesco.
While China has been gradually opening its bond markets to foreign investors since 2010, this did not immediately result in a substantial inflow of foreign money. ‘It is only in the last four to five years that we see an acceleration, following improvement of the market infrastructure and the internationalisation of the renminbi,’ says Wong.
China’s central bank is promoting the renminbi as a world reserve currency and has concluded currency swap agreements with foreign central banks. ‘This increases the liquidity of the onshore renminbi bond market and therefore makes it more attractive for foreign investors to invest in it,’ says Wong. As a result, index builders have also included Chinese government bonds in their indices. As of October 2021, they will be part of the FTSE Russell World Government Bond Index. Last year, Chinese RMB debt securities already made their debut in the Bloomberg Barclays Global Aggregate, the most popular global bond index.
Huge inflows
According to Wong, inclusion in these benchmarks has resulted in higher inflows of foreign money. ‘International investors now hold around 9% of onshore Chinese bonds, up from only a few percent just a few years ago.’ These bonds are Chinese RMB government bonds and bonds issued by the three Chinese state-owned banks: the China Development Bank, the Agricultural Development Bank of China and the Export-Import Bank of China.
This onshore bond market is noq worth more than USD 15 000 billion and is still clearly under-represented in global benchmarks. China is already the second largest bond market in the world, and China’s weight will, of course, continue to grow, but this will be done very gradually in order to avoid major price shocks. Inclusion in the Bloomberg Barclays index alone leads to a potential annual inflow of $200 to $400 billion’, says Wong. ‘Eventually, international bond investors will further increase their exposure to China and their share will rise to 40-60%.’
Central banks will follow the example of other international investors, as the international role of the renminbi as a reserve currency becomes more important. ‘They will hold more renminbi reserves and will want to invest them safely in Chinese government bonds. Beijing leaves no room for misunderstanding about its plans: foreign ownership of financial assets in China will only increase.’
Local debt mountain
The Chinese 10-year bond yield of 3.2% looks very attractive compared to negative yields in the euro area and the US 10-year rate of around 0.8%. ‘The level of Chinese yields fits well with the expected long-term sustainable economic growth of the Chinese economy of 3 to 4% per annum,’ says Wong. ‘Unlike other central banks, the People’s Bank of China has no quantitative easing programmes. Also, inflation is not far from the 3% target. This makes the situation in China much healthier than in the United States.’
The current spread of more than 200 basis points compared to ten-year US Treasuries is on the high side as well, notes Wong. He points out that in 2016 the spread was still around 80 basis points, while China now has a relatively strong fiscal position and has also contained the pandemic. ‘Partly because China, unlike the United States, is in control of the virus and the Chinese economy is recovering quickly as a result, the renminbi has risen sharply against the dollar this year. I certainly see room for further appreciation of the renminbi in the long term, but there is now also speculation going on and the risk of profit taking is increasing. Some short-term caution is therefore warranted,’ warns Wong.
He is not worried about the high debts of local governments and the often hidden debts within local government financing vehicles. ‘Borrowing is not a problem as long as you generate cashflow and can repay the debts. Especially for China, growth is necessary, because here you don’t have negative interest rates like in Japan and Europe. If China cannot maintain its economic growth, then the mountain of debt of local governments in China will become a problem. However, I do not see any major obstacles that could steer China off its current growth path.
Wong does not yet want to call Chinese government bonds a safe haven. ‘During the peak of the corona crisis in March, everything was sold off and we saw spreads rising globally. However, Chinese government bonds remained extremely stable. Seen in that light, they do offer investors a great deal of security. But they will only be a safe haven if the renminbi is given reserve currency status. That will take some time.’