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Week in Review: Shanghai slide
China’s $11.4 trillion bond market is the third-largest in the world but remains relatively uncharted territory for global investors. Many view this market as a vast investment opportunity - but some regard it as a minefield.
Admittedly, these are trying times for the Chinese bond market. While regulatory tightening and curbs on shadow financing are much-lauded moves, they are taking a toll on the funding of private companies. Credit flows have slowed and surging corporate borrowing costs have made it harder to refinance debts, and some believe rising corporate defaults could rattle investors. But we beg to differ.
It isn’t just about size
Given the size and favourable attributes of the Chinese domestic bond market, it would be sensible for international investors to familiarise themselves with the nuances of the market.
Already, the Bloomberg-Barclays Global Aggregate Index has decided to include renminbi (RMB)-denominated government and policy bank securities. This will commence in April 2019, subject to policymakers implementing a number of enhancements - such as the availability of delivery-versus-payment for the settlement of trades. Other major indices like the Citi World Government Bond Index and the JP Morgan Government Bond Index-Emerging Market could follow, further supporting the market’s prospects.
China’s markets have remained relatively closed despite its being the world’s second largest economy. The domestic debt market is underdeveloped and foreign ownership is extremely low. But this is changing.
China’s bond market is primarily domestically-driven and has historically been less correlated to other emerging and developed market bond markets, providing potentially good diversification benefits for international investors, particularly amid global shocks.
Another favourable attribute is that China has a fairly low dependency on external funding. China’s external debt stood at US$1.68 trillion as of end-2017 or slightly over 13% of GDP. (State Administration of Foreign Exchange’s website) As a percentage, this is one of the lowest in Asia and emerging markets. Overall government debt is only around 37% of GDP - again, considerably lower than many of its developed market peers. With US$3.22 trillion (State Administration of Foreign Exchange, China) in foreign reserves and other assets in sizeable sovereign wealth funds, China also has considerable assets at its disposal.
Growth has rebalanced and is increasingly domestically-driven, supported by an explosion in the middle class and, while declining, it has run current account surpluses for several years.
Sources of liquidity
The Chinese government is a one-party political system, and this dominates all aspects of policy-making. Chinese policymakers are in the somewhat enviable position of being able to think about long-term policies that supersede political cycles.
As in other markets, the bond market in China plays a crucial role in financing long-term development, providing capital either to the government or its many key agencies. With the capital market beginning to open up, foreign investors are increasingly able to participate in the provision of capital. Both government and quasi-government bonds are investors’ top targets in China.
State entities executing national policies or policy banks that finance national development projects are attractive options for RMB bond investors. Quasi-state enterprises are also viable options, including those that operate the national grid and major oil and gas fields, and are involved in hydropower generation. Higher-rated companies or those with an international investment-grade rating are also on investors’ radar.
Credit analysis of the bond issuer and their priorities is crucial. China still has much ground to cover in terms of good corporate governance, financial transparency and investor protection.
Defaults are rising, and this is very important for addressing moral hazard and allowing for more differentiated pricing of credit risk. Nevertheless, this underscores the need for a diligent approach to assessing credit risk. As of 4 June 2018, 12 onshore bond issuers have defaulted on 21 bonds with a total principal amount of RMB20.2 billion. (Bond refinancing risk rising for Chinese corporates’, Fitch Ratings) And the first bond default by a local government financing vehicle is likely this year. Still, such non-payment may help allocate resources more appropriately between state-owned enterprises and private companies.
Similar priorities, differing impacts
Interestingly, bond yields in China, which have been above those of the US for almost a decade, have started to converge. Both countries want to avoid the build-up of inherent risks.
After several years of very accommodative policy, the US is raising interest rates as a result of sustained improvements in growth, in order to avoid inflation risks developing. This has driven yields higher from multi-decade lows. China, which has already experienced a sharp rise in yields since 2016, has had to tighten a wide range of policies in order to tackle rapid credit growth, environmental pressures and corruption. This demonstrates a willingness to sacrifice short-term growth in order to achieve more balanced, sustainable and higher quality growth. With growth expected to slow, inflation stable and foreign inflows picking up, the bond market has found strong support.
Policymakers in China will have to step in at some point to soften leverage curbs and ease monetary policy. Already, a cut in the reserve requirement ratio released about RMB700 billion (People’s Bank of China) to spur lending to the private sector. Regulators may also allow issuance of bonds beyond the purpose of just refinancing maturing bonds.
Overall, with highly-competitive yields, a market where the interest rate trajectory is trending down, a low correlation to other markets and relatively lower currency volatility, there certainly is an investment case for onshore China bonds.
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