Why do smart people do obviously ‘irrational’ things? It must be the
incentive structure, so for them they do not seem irrational. So, I am wrecking
my brain over China’s decision to issue EUR-denominated bonds (and a few weeks
ago USD-denominated ones), in light of its goal of CNY and CGBs
internationalization, 40-50bps over the CGB curve (swapped in EUR).
The rationale China is putting forward is that enables it to diversify its investor
base on the back of the trade tensions! Seriously? Do they really mean that or
are they getting a really bad advice? Wasn’t the intention to actually go the
other way as a result of the trade war? Didn’t China want to be become more
self-reliant? In any case, China does not need foreign currency funding given
its large, positive NIIP. China has the opposite problem. It has too much idle
domestic savings and not enough domestic financial assets. This, among other
things, creates a huge incentive for capital flight which, despite its closed
capital account, China is desperately trying to prevent.
In that sense, China does need foreign investor but to
invest in CGBs (and other local, CNY-denominated bonds) to act as a buffer to
the potential domestic capital outflow as the capital accounts gates slowly
open up. It is for this reason that BBGAI and JPM have started including CGBs
into their indices this year.
It is for this reason SAFE decided to scrap the quota restrictions on both QFII and RQFII in
September. It is for this reason that Euroclear signed a memorandum of understanding
with the China Central Depository & Clearing to provide cross-border
services to further support the evolution of CIBM. That opens up the path for
Chinese bonds to be used as collateral in international markets (eventually to
become euro-clearable), even as part of banks’ HQLA.
All these efforts
are done to make access to the local fixed income market easier for foreign
investors. And now, what does China do after? Ahh, you don’t need to go through
all this, here is a China government bond in EUR, 50bps cheaper (than if you go
through the hassle of opening a Bond Connect account and hedging your CNY back
only goes against China’s own goals regarding financial market liberalization but
also against the recent trend of other (EM) markets preferring to issue in domestic
currency than in hard currency. And while other EMs may not have had the choice
to issue in hard currency from time to time, China does. And while the investor
base for other EMs between the domestic and the hard currency market is indeed
different, and the markets are very distinctive, China does not have much of an
international investor base. Issuing in the hard currency market may indeed ‘crowd
out’ the domestic market. Especially when you come offering gifts of 50bps in a
negative interest rate environment.
When speaking to investors, the two most common questions I get asked, given rather extreme levels and valuations of (most) asset classes, are:
asset allocation change dramatically going forward? and
the best risk diversifier for my portfolio?
I have previously
opined on this here.
Very broadly speaking, on the equity portion, one should reduce exposure to US
equities and increase allocation to EM equities (unhedged). On the fixed income
side, one should move completely out of the long end of UST and put everything into
T-Bills to 2yr UST; exposure to EU-denominated sovereigns should also be reduced
to zero at the expense of EM local (unhedged) and hard currency bonds. In the
normally ‘Others’ section of the portfolio, one should include soft commodities
(or alternatively, scale everything down to make space for them). Finally, in
terms of FX exposure, apart from EM currencies through the unhedged portions of
the bonds and equities allocations, one should hedge the USD exposure with EUR.
Here I am
adding some more general thoughts on what I consider to be the best portfolio
diversifier for the next 5 years, possibly even longer. To my knowledge, ‘noone’
is invested in any meaningful way in Chinese bonds (I am excluding the special
situations credit funds, some of which I know to be very active in the Chinese credit
space – but even they are not looking at Chinese government or bank policy
fixed income funds, the pension/mutual funds, the insurance companies have zero
allocation to Chinese bonds. Some of the index followers started dipping their
foot in the space but most of them are either ignoring China’s weight or are massively
underweight the respective index. Finally, a sign of how unloved this market
is, on the passive/ETF side, the biggest fund is just a bit more than $100mm.
Let me just
say here that we are talking about the third (possibly even the second, by the end
of this year) largest fixed income market in the world. And no one is in it?
Chinese bonds merit a rather significant place in
investors’ portfolios. They offer diversification thanks to their low
correlation and superior volatility-adjusted return relative to other developed
and emerging markets. In addition, Chinese bonds are likely to benefit significantly from
both the passive and active flows going forward: I expect up $3 trillion of foreign inflows
over the next decade on the back of indexation.
Bloomberg Barclays Global Aggregate Index (BBGAI) and JP Morgan Global
Diversified have already confirmed Chinese bonds inclusion in their respective
indices. FTSE Russell WGBI is likely to do that next March. This inclusion is a big deal! It
will have huge repercussions on the global bond industry. It is a much more
important and far-reaching development than a similar inclusion of Chinese
equities in global indices last year. And the market is not only not ready for
this, but it is also underestimating its impact overall.
China is a
highly rated sovereign with a much better risk/return profile than other
high-quality alternatives. Chinese bonds
offer a significant scope for portfolio diversification because they have very low correlation to global interest
rates which means lower return volatility.
Therefore, China sovereign bonds offer a much
better volatility-adjusted return than Global Bonds, EM Hard Currency and Corporate Bonds, US HY and
Equities, Global Equities and Real Estate.
Among the plethora of negatively yielding sovereign bonds, China sovereigns offer a good pick-up over other DM bonds while yielding not too much lower than EM bonds. In addition, they offer much more opportunity for alpha generation than both DM or EM sovereign bonds. This alpha partially comes from the fact that Chinese fixed income market is still not so well developed and partially from the fact that there are not many sophisticated foreign players in it, as access to it is still not that straightforward.
things are rapidly improving on the access side. Bond Connect has already
started to revolutionize the onshore market. Before the setting-up of CIBM, and
especially Bond Connect in 2017, access to the China bond market was extremely
cumbersome through a lengthy process requiring approvals from high authority (QFII
and RQFII). Bond Connect, on the other hand, does not require domestic account
and custody while following international trading practices. In addition, not
long ago, it started real-time settlement and block trading. As a result, Bond
Connect volumes doubled.
in September this year, SAFE decided to scrap the quota restrictions on both QFII
and RQFII, while Euroclear signed a memorandum of understanding with the China
Central Depository & Clearing to provide cross-border services to further support
the evolution of CIBM. That opens up the path for Chinese bonds to be used as
collateral in international markets (eventually to become euro-clearable), even
as part of banks’ HQLA. Such developments are bound to make access to the
Chinese bond market much easier for overseas investors.
to be a very important month for the China bond market also because the authorities
finally delivered on the interest rate reform agenda. The central bank eliminated the benchmark policy loan and deposit
rates in favor of a more flexible reference rate. This should be positive
for yield curve formation and the continued expansion of interbank liquidity.
China does not have some of the weaknesses typical of emerging markets. On the opposite, it has very little sovereign FX debt, has large FX reserves, and it is a net creditor to the world. Moreover, some of the foreign debt is most likely offset by foreign assets.
Corporate-sector leverage, however, is still high, though default rates, despite lots of recent media focus, are still relatively low. On the other hand, the recovery rates are high, while the official, banking and household sectors are in relatively strong position which, reflects degrees of freedom to deal with these challenges. China has large amounts of debt with implicit state backing and a culture averse to defaults. In effect, the government controls both the asset and the liability side of the domestic debt issue thus a debt crisis is much less likely than in a fully free-market economy. The fact that China has the ‘fiscal’ space to deal with the private debt issue is one big advantage it has over DM countries with similarly high private debt burdens but which have also already used the option of shifting that debt to the government balance sheet.
The high debt issue and the authorities’ attitude to it, the structure of the economy (export-driven) as well as the potential transition from an extremely high growth rate to a more ‘normal’ one, makes China’s situation very similar to Japan’s in the late 1980s. Yet, there are also major differences. China’s urbanization rate is much below Japan’s before the 1990 crisis, the real estate bubble is only in the top tier cities as opposed to country-wide as in Japan, the Renminbi is more likely to depreciate going forward than massively appreciate which is what happened to the Yen after the Plaza accord.
The high debt issue is a problem China shares not only with Japan but also with most advanced countries in the world. Similar to them, China is fully sovereign (the government has full control of the overall economy balance sheet; the currency peg is a “question mark”, not a real issue given China’s large positive NIIP). Of all these advanced economies with similarly high non-financial debt to GDP, only China has not reached the zero-bound*. It is, therefore, likely for the Chinese policy rate to continue to move lower until it eventually hits 0%.
Similar to Japan, it has a high household savings rate and a rapidly ageing population. Yet, Chinese households have relatively low exposure to financial assets and especially to bonds. Given the policy agenda of financial market reform and the life-cycle savings behavior (i.e. risk-aversion increases with age), Chinese households’ allocation to bonds is bound to increase manifold. Moreover, with the looming of the property tax law (sometime next year), I expect the flow into bonds to start fairly soon.
flow aspect makes the case for investing into China bonds much stronger. Given the size of the Chinese fixed income market, its
rapid growth rate and the reforms undertaken most recently, global bond indices had ignored
Chinese bonds for too long. However, last year BBGAI announced that it would
include China in its index as of April 1, 2019. Purely as a result of this, China bond inflow is expected to reach
$500Bn by 2021 as the weights gradually increase from 0.6% to 6%. By then
China will be the 4th largest component in the index (after US,
Japan and France – and bigger than Germany!)
BBGAI’s inclusion, there had never been a bond market that large, that was not
included in an index, as the Chinese bond market. In fact, China already represents the third largest bond market in the world,
growing from $1.6 trillion in 2008 to over $11 trillion now.
And even after these
inflows, China bonds are still likely to remain relatively under-owned by
foreigners as they would represent just 5% of China’s total bond market (currently foreign ownership of the overall bond market is around 3%,
PBOC expects it to reach 15%). Foreign ownership of China sovereign bonds (CGBs)
is slightly higher, but even at around 6%, it is materially lower than in other
major sovereign bond markets. This under-ownership is even more pronounced relative
to the emerging market (EM) universe (the ranges there are between 10% and 50%).
foreign investors are expected to continue to get very favorable treatment from
the Chinese authorities. The government has an incentive to make things easier as they need
the foreign inflows to balance the potential domestic outflows once the current
account is liberalized. For example, the tax changes implemented last year allowed
foreigners to waive the withholding tax and VAT on bond interest income for a
period of three years.
I am still
frankly shocked how little time investors have to discuss these developments
above but, at the same time, how eager they are to discuss the Chinese economy
and the trade tensions. From one hand, they acknowledge the importance of China
for their investment portfolio, but on the other, they continue to ignore the
elephant in the room being the Chinese bond market. I understand that this choice
is perhaps driven by investors’ inherent negative bias towards any Chinese
asset, but the situation between asset and asset is much more nuanced.
fixed income space, one can be bearish select corporate credit and bullish CGBs
or bank policy bonds (in fact, the more bearish one is on corporate credit, the
more bullish sovereign bonds one should be). Finally, I do acknowledge that the
big unknown here is the currency. But even there, the market has become much
more sophisticated: one can now use a much longer CNY/CNH forward curve to hedge.
Bottom line is that if you are still looking for a fixed income alternative to diversify your portfolio and you are not looking at Chinese sovereign bonds as an alternative, you are not being fiduciary responsible.
*For more details, see JP Morgan’s economics research note, “China’s debt: How will it evolve?”