Anyone born since the 1990s knows China as an economic powerhouse — the world’s second-largest economy. Yet back in 1978, it was a poor country with a largely rural population.1
Many people will be familiar with the story: following decades of economic mismanagement, radical economic reforms launched in 1979 unleashed China’s animal spirits. Domestic growth coincided with an extended period of globalization, when labor, trade and investment flowed largely unimpeded around the world.
Growth was largely achieved without foreign capital. Savings in China have always been abundant. People made deposits at state-owned banks, which lent the money to state-owned enterprises. The government determined the loan amount, tenor and interest rate. However, there are problems with this model. It led to the misallocation of capital. It is also poorly equipped to deal with aging demographics — how do you harness bank savings to pay the pensions of a graying population? Pensioners in China need to invest in bonds that pay coupons and mature at par. They also need to make long-term equity investments that pay dividends. Both these priorities require credit and equity cultures that currently do not exist.
Recently, policymakers opened up the domestic capital markets to foreign investment, to fast-track their development. While many investors have heard of A-shares, the country’s onshore bond market is less well known. This is despite the recent inclusion of yuan-denominated Chinese government bonds (CGBs) in three influential global indices. For example, CGBs will be included in the FTSE World Government Bond Index from October 2021.2 The J.P. Morgan Government Bond Index – Emerging Markets, started tracking CGBs earlier this year. Their weighting is expected to hit 10% by year-end.3 The Bloomberg Barclays Global Aggregate Index got the ball rolling in April 2019.4
China’s $12 trillion onshore bond market (as of end-2019)5 is the world’s second largest6 and may represent an opportunity for some fixed-income investors. Foreign investors account for only 8% of the CGB market because of access issues in the past that have now been resolved.7 By contrast, foreign investors make up some 50% of the German and Australian government bond markets.8,9
CGBs, yielding more than 3%, are beginning to attract greater investor interest from outside China. This is because yields on 10-year bonds issued by governments in developed markets are negligible.10 They offer better relative value, even though the country is the first of the major economies to rebound from lockdown-induced economic disruption. In our view, China is the only major economy that will grow in 2020, and the pace of growth is expected to accelerate next year.11
As a result, monetary and fiscal policy continue to be relatively orthodox — the People’s Bank of China hasn’t exhausted its options (in contrast to central banks in the developed markets). This gives Chinese policymakers room to respond if more stimulus is needed.
Earlier this year, amid growing panic as Covid-19 spread beyond Asia, trading ground to a halt in nearly every capital market. There was, however, one notable exception. Back in March, liquidity dried up even in the U.S. Treasury market, usually considered the safest asset class.12 And yet, on the other side of the world, CGBs continued to trade without a hitch. Changes to global bond indices may bring more foreign investment in Chinese government debt as passive investors adjust their holdings to mirror these updates13 (see chart).
Source: PIIECharts, December 2020
Ironically this comes at a time when some headwinds are growing. International public opinion has turned against China since the emergence of Covid-19.14 The strategic rivalry with the U.S. continues, and a Joe Biden presidency may herald a more united Western approach to the country.
But despite shifting geopolitics, the world cannot ignore China. Since President Donald Trump announced the U.S. withdrawal from the Paris climate accord in 2017, China has played a leading role in tackling climate change. It has committed to becoming carbon neutral by 2060.15 The country already dominates the supply chains that support many green industries.16
In recent years, there has been a global tendency to look inward and to reject anything the outside world has to offer. China’s capital markets are fighting this trend. As the bond market grows it will help support the next stage of national development. Here, at least, foreigners are still welcome.
1 IMF, China’s economic growth and poverty reduction (1978-2002), A.G Hu, L.L. Hu, Z.X. Chang, 2003
2 FTSE Russell Press Release, September 24 2020
3 Reuters, JPMorgan inclusion adds shine to rising Chinese bonds, February 28 2020
4 Bloomberg Press Release, March 23 2018
5 UBS, Will opening of a potential US$35trn China bond market support growth in global financials, September 7 2020
7 FTSE Russell, Chinese bond market – Evolution and characteristics, July 2020
8 Deutsche Bundesbank, Monthly Report, July 2018
9 Australian Office of Financial Management [retrieved on November 26 2020]
10 Bloomberg, November 26 2020
11 Aberdeen Standard Investments Research Institute, Global Economic Outlook – Vaccines vs the second wave, November 19 2020
12 The Brookings Institution, How did COVID-19 disrupt the market for U.S. Treasury debt?, J. Cheng, D. Wessel, J. Younger, May 1 2020
13 Reuters, China bond inclusion in WGBI may drive $140 billion in inflows: Goldman Sachs, September 8 2020
14 Pew Research Center, Unfavorable Views of China Reach Historic Highs in Many Countries, October 6 2020
15 BBC, Climate change: China aims for ‘carbon neutrality by 2060’, M. McGrath, September 22 2020
16 Sanford C. Bernstein, Bernstein Hydrogen: Making money in fuel cells - lessons from solar, wind and batteries, October 2020
Foreign securities are more volatile, harder to price and less liquid than U.S. securities. They are subject to different accounting and regulatory standards, and political and economic risks. These risks are enhanced in emerging markets countries.
Fixed income securities are subject to certain risks including, but not limited to: interest rate (changes in interest rates may cause a decline in the market value of an investment), credit (changes in the financial condition of the issuer, borrower, counterparty, or underlying collateral), prepayment (debt issuers may repay or refinance their loans or obligations earlier than anticipated), call (some bonds allow the issuer to call a bond for redemption before it matures), and extension (principal repayments may not occur as quickly as anticipated, causing the expected maturity of a security to increase).
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