Commentary
The Trump administration has been curbing market access for certain Chinese companies associated with the Chinese Communist Party regime.
Despite escalating tensions between Beijing and Washington, the United States and other foreign investors are providing funds to amplify China’s growth and its apparent economic rebound since the depths of the CCP virus pandemic.
While foreign participation in the Chinese stock market has been widely documented, participation in its onshore bond market has just begun and is becoming a meaningful countercurrent to Washington’s efforts to curb the Chinese regime’s ambitions.
And much of this is the United States’ own doing—a combination of the low-interest rate policy adopted by the West and inclusion into securities indices by Wall Street.
Foreign participation in China’s $15 trillion onshore (RMB-denominated) bond market was a negligible 2.9 percent as of August, according to French brokerage firm Natixis. But that figure is about to change very soon. A few developments could boost that percentage significantly.
The first development is China’s apparent liberalization of its bond market. On this front, Beijing has swung the door wide open.
Until a few years ago, international investors had to go through a lengthy process to apply to become a Qualified Foreign Institutional Investor (QFII) or Renminbi Qualified Foreign Institutional Investor (RQFII) to invest. Even with the license, they were subject to a slew of restrictions, caps, and repatriation limits. In 2017, the Hong Kong-based Bond Connect granted foreign investors broader access to the mainland market.
In September, regulators introduced new draft rules to ease the application process further, paving the way for even broader access.
The next two developments pushing capital to Beijing are driven by the West’s own policy. One trend is Wall Street’s inclusion of the Chinese market into its numerous securities indexes.
In April, Chinese bonds were added to the Bloomberg Barclays Global Aggregate Bond Index, the world’s most widely followed investment-grade fixed-income index. Chinese state media China Daily estimates about $700 billion to $800 billion of capital inflows from foreign funds, insurers, and banks as a result of this addition.
Chinese government bonds also will be added to U.S. investment portfolios. JPMorgan Chase in February added Chinese government bonds into its JPMorgan Government Bond Index—Emerging Markets, which is expected to drive more than $20 billion of foreign capital into Chinese government bonds.
In September, FTSE Russell announced it would add Chinese government bonds to its World Government Bond Index next year, which may trigger another approximately $100 billion of inflows into Chinese government bonds.
So far, these three index additions might drive almost $1 trillion of aggregate new foreign money into the Chinese onshore bond market in the near future. Aberdeen Standard estimated in 2018 that China could make up 5 to 7 percent of these three indices, with more possibly to follow.
The third factor—and perhaps most powerful—is the significant yield gap. Government and corporate bonds in the United States and Europe pay such little interest that many investors are forced to go elsewhere to obtain sufficient returns. This is especially true for pension funds and insurance companies that must meet certain returns in order to generate sufficient cash to pay liabilities. The trend is a manifestation of the prevailing low-to-zero-percentage interest rate regime which has been in place in the West since the Great Financial Crisis. And the CCP virus has turned expectations of interest rates further into the negative in some countries.
As of Oct. 2, the one-year U.S. Treasury bill yields just 0.1 percent, while the 10-year U.S. Treasury rate is 0.7 percent. Today, Treasuries have become less of an investment and more of a store of value.
Yields on Chinese debt are comparatively higher. As of Oct. 2, Chinese 10-year government bonds yield 3.1 percent, and an Export-Import Bank of China bond due March 2030 yields 3.8 percent. China’s central bank has largely eschewed stimulus recently and held rates steady in an effort to promote financial stability domestically.
In today’s environment, a spread of 2.5 percent is very tempting.
China is by no means the highest-yielding market. But investors view China’s relative currency stability (managed to the U.S. dollar), historically low default rates (also centrally managed), and increasing market access as more attractive compared to other high yielding emerging markets. There are few alternatives; for example, India’s financial markets are almost completely shut off from foreign investors.
So to meet returns expectations, institutional investors are essentially shrugging off massive risks arising from arbitrary CCP policies, draconian capital controls, and pervasive corporate governance and judicial concerns.
So far, China’s onshore bond market has largely avoided the foreign scrutiny that its stock markets have attracted. The South China Morning Post reported on Sept. 30 that foreign fund managers sold a net 24 billion yuan ($4 billion) of yuan-traded equities via the Hong Kong-Shanghai Stock Connect during the third quarter. It’s a signal that foreign investors could be becoming leery of Chinese stocks.
While Chinese bonds are less talked about than stocks, they absolutely warrant similar scrutiny.
