Asia: China debt breakthroughs meet investor indifference
Bond Connect programme confirmed; long-term potential means little today.
With the planned launched a of a new bond-trading link between Hong Kong and the mainland and the inclusion of Chinese domestic bonds in some international indices, it appears that international access to the world’s third-largest debt market is easier than ever. But don’t be fooled, we are still years from meaningful engagement of international capital in this Rmb64 trillion ($9.3 trillion) market.
“Keen would be an overstatement,” says Chantal Grinderslev, senior adviser at Z-Ben Advisors in Shanghai, when asked if her international clients are keen to get greater exposure to Chinese domestic bonds. “Bond inclusion right now is a non-issue.
“There’s a general acknowledgement that the fixed income market has potential in the long term. Unfortunately, long-term potential means underinvestment today in managers’ capabilities to service those flows.
“We’re talking about the world’s second-largest economy, third-largest fixed income market and yet most global asset managers have zero exposure to renminbi fixed income.”
Foreigners held only 1.3% of China’s interbank market at the end of 2016. The definition of an interbank market is different in China to elsewhere in the world: in China, it accounts for more than 90% of all traded bonds in the country.
The parallel tracks adopted for index inclusion have largely given asset managers the choice to opt in or opt out of China. Most are opting out. China just isn’t a priority and renminbi fixed income even less so - Chantal Grinderslev, Z-Ben Advisors
Is that about to change? It has never been easier than it now is (or soon will be) to gain exposure. For years, foreign institutional investors have had to wait for quota through the QFII (qualified foreign institutional investor) or R-QFII (renminbi QFII) schemes.
Then in February last year, the People’s Bank of China (PBoC) opened the market to international buyers directly, albeit under a sponsor regime that requires investors to buy through an approved bank.
In February this year, the PBoC allowed foreigners buying bonds onshore to hedge the currency risk of doing so through FX forwards and swaps.
Then in March, rumours of a Bond Connect programme to run alongside the Stock Connect system that connects Hong Kong and the mainland for equities were confirmed by premier Li Keqiang. This system should be in place by the end of the year. Much like Stock Connect, it will not require investors in Hong Kong (which can include all internationals who open accounts there) to open accounts onshore, but will allow them to trade in mainland bonds directly through their existing Hong Kong-based accounts.
“It looks like it will happen very soon. We think they will open up northbound first [Hong Kong to the mainland], then southbound later,” says Thomas Kwan, managing director and CIO at Harvest Global Investors, one of the largest Chinese asset managers with over $100 billion under management.
“Basically it will allow most foreign investors to be able to invest in the domestic bond market.” There are still technical details to be clarified, particularly around over-the-counter trading in China, but Li’s announcement makes it a certainty that the programme will go ahead.
Although a declining renminbi against the dollar is an impediment to foreign flows into Chinese debt, Kwan points out that only applies to dollars. “The renminbi has been stable against the euro, for example,” he says. “If I am already invested in global bonds, I can gain significant yield by switching to Chinese government bonds.”
It has long been argued that inclusion in international indices would prompt greater international inflows into the market (estimates go as high as $200 billion of potential inflows, although even that would be barely 2% of the whole market). In this respect there has been some progress, but it requires closer scrutiny.
In March, Citigroup added Chinese domestic bonds to three sub-indices: its Emerging Markets Government Bond Index, Asian Government Bond Index and the Asia Pacific Government Bond Index. Bloomberg Barclays, another key index provider, has created variations of its existing benchmarks, so in addition to its Global Aggregate Index, there is a Global Aggregate + China Index and also an Emerging Market Local Currency Government + China Index.
Both events were considered important, but they do not oblige capital in the main benchmarks to allocate to China; they just create a side option for it to do so. Perhaps a few billion dollars track these Citi products. Compare that with, say, the JPMorgan GBI-EM index, which is tracked by more than $200 billion of funds, or even the World Government Bond Index by Citigroup (which still does not include China), which had a market value of $19.97 trillion at the end of March.
“The parallel tracks adopted for index inclusion have largely given asset managers the choice to opt in or opt out of China,” says Grinderslev. “Most are opting out. China just isn’t a priority and renminbi fixed income even less so.” There are exceptions, she says, that are interested and engaging, but “for the rest, China strategies typically translate to equities capabilities or holistic avoidance”.
Still, it may be that Bond Connect increases access sufficiently to allow the big guys, like the JPMorgan index, to include domestic bonds. “With Bond Connect, I don’t think there will be any hurdle to inclusion,” says Kwan. “Within the next six to 12 months, we could see two or three bond indices including China.”
Either way Hong Kong is happy with the direction things are taking. The Hong Kong Stock Exchange gains more than anyone from Bond Connect, since it becomes a gateway through which the world can invest in Chinese debt. An exchange statement in March called it “a major breakthrough in the development of the mainland capital markets”.