Some $140 billion may flow into China’s onshore bond market after the index provider, FTSE Russell, adds debt issued by the Chinese government to one of its widely followed benchmarks, according to recent research.1
FTSE Russell announced these changes to its World Government Bond Index (WGBI) on September 25, 2020. Inclusion of Chinese government bonds (CGBs) will start next year, subject to final confirmation. The move brings the company in step with the compilers of the Bloomberg Barclays Global Aggregate Index and the J.P. Morgan Government Bond Index - Emerging Markets.
More international investment in China seems counterintuitive in these troubled times of mounting U.S.-China rivalry. This is a strategic rivalry that will lead to further de-coupling for the world’s two largest economies, raising hurdles to trade and investment. Ahead of one of the most contentious U.S. presidential elections in living memory, the need for a tougher stance on China seems to be the only issue that Democrats and Republicans agree on.
This said, we have seen strong interest from international investors, such as sovereign wealth funds and Australian superannuation funds, in renminbi-denominated CGBs. Interest has pushed foreign ownership to record levels, albeit from a low base. Foreign investors accounted for about 2.8 trillion yuan ($413.8 billion) of the 110 trillion yuan market, as of end-August.2
Investors in Europe, Latin America and Australia, have extended their existing interest in A-shares – those listed on mainland China’s stock exchanges – to the country’s government bonds. These investors recognize the relative value on offer. For example, 10-year CGBs yield 3.12% compared to the 0.67% from dollar-denominated 10-year U.S. Treasury bonds.3
Yields are higher even though China looks as if it will be the first major economy to rebound from the pandemic-induced lockdowns that have battered growth this year. China’s monetary policy is shifting back towards a focus on financial stability (as opposed to stimulus). In recent months, tighter monetary policy – restricting the supply of money within the financial system – has pushed Chinese bond yields above pre-pandemic levels. By contrast, yields in other major bond markets have been pushed lower by monetary expansion in those jurisdictions.
Granted, relative yields may not look as attractive after hedging costs from buying financial instruments to mitigate currency risk are included. But the additional yield offered by CGBs versus the government bonds of developed markets provides a buffer against further market volatility. This is not the case in the mature economies where interest rates are already close to zero, government bond yields are negligible and central banks are running out of options with regard to monetary policy.
China has a big incentive to keep the renminbi stable. The value of the yuan has been allowed to fluctuate more in line with market forces since 2014, as China wants its currency to play a bigger role in international trade and investment. Even so, it trades within bands set by policymakers who try to dampen any excessive volatility. A sharp depreciation of the yuan would feed accusations of currency manipulation, amplifying existing tensions with the U.S.
Meanwhile, the People’s Bank of China, the country’s central bank, has the tools to offset any liquidity drain should foreign investors suddenly pull out of the bond market. State direction within the banking system remains a powerful policy lever that can help support bond prices in the event of market disruption caused by capital outflows.
So far, the bond market has escaped the overseas scrutiny and censure directed at Chinese companies in the equity markets
So far, the bond market has escaped the overseas scrutiny and censure directed at Chinese companies in the equity markets. It is conceivable that the spotlight may eventually swing towards CGBs, should the U.S.-China relationship deteriorate even further. However, equity investments will likely remain more sensitive given the politics around the issue of reshoring – the return of manufacturing back to a company’s country of origin.
In fact, CGBs may offer a compelling hedge against A-shares. CGBs and A-shares together can be used to seek to mitigate risk for one another in the short term, while generating positive potential returns over the long term. The relationship is not unlike the historical relationship between the S&P 500 Index and U.S. Treasury bonds.
There is a risk that markets underestimate (or struggle to price appropriately) the deeper structural de-coupling that is taking place between the U.S. and China. This is a long-term process which will have implications for globalization, capital flows and technology development.
However, Chinese government bonds remain relatively insulated. While the inclusion of these securities into the WGBI will lead to more passive investment, there are plenty of better reasons for investors to sit up and take notice.
1 Reuters, China bond inclusion in WGBI may drive $140 billion in inflows: Goldman Sachs, September 8 2020
2 Bond Connect website and WIND, September 2020
3 Bloomberg, September 17 2020
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