When the history of 21st century finance is written, two dates in 2016 are likely to deserve special mention: February 24 and October 1. On these two days China fully opened its $12 trillion interbank bond market to foreign investors and joined the IMF’s Special Drawing Rights (SDR) basket of currencies, effectively conferring reserve currency status on the renminbi.
The news about China may be dominated by president Donald Trump’s tariffs. But China’s paramount leader, president Xi Jinping, is unlikely to be overly concerned by headlines. His eyes are on the future. As Adam McCabe, head of Asia fixed income at Aberdeen Standard Investments, which has $779 billion in assets under management and has been invested in Chinese bonds since 2011, says: “The world is focused on the China/US relationship. China is focused on everywhere else.”
The long-term goal of China has been to supplant the US as the global economic superpower. Without some unforeseen catastrophe, this has long been regarded as a mathematical certainty: China is growing faster than the US and its population is four times bigger. But until very recently it was less clear what role China would play in the global financial system. Its markets were closed or placed burdensome restrictions on foreigners and its capital account is only inching open because the authorities are fearful of outflows.
The internationalization of the renminbi is accelerating. The Belt and Road Initiative is the greatest exercise in soft power and hard economic clout since the Marshall Plan helped rebuild post-war Europe. It will create a trade bloc for the renminbi covering 40% of world GDP. The opening of its bond markets already puts China on a par in size with Japan.
The ultimate goal is for Chinese Government Bonds (CGBs) to supplant US treasuries as the global benchmark backed by a reserve currency. That may sound absurd. Foreign participation in Chinese bond markets is tiny – only 7% of CGBs and less than 2% of local credit. But by a process of both compulsion and attraction the role of CGBs in global bond portfolios is set to increase exponentially.
Index providers have taken note of China’s new attitude toward foreign investors. Bloomberg Barclays has announced that China will be included in its widely followed Global Aggregate index from April 2019. With a weighting of 5.9%, China will become the third-biggest bond market in the index overnight. Other global index providers, including FTSE, which operates the World Government Bond Index, and JPMorgan, best known for its range of emerging market indices, are reviewing Chinese inclusion and are likely to follow suit.
“Index inclusion is a game changer,” says McCabe. “It forces investors to think about what they are doing in the market. Not owning China is a big underweight, so an active management decision. But more than that, it will compel asset allocators and asset owners to formulate a China strategy.”
CGBs are likely to prove attractive to both global asset allocators and emerging market specialists. The People’s Bank of China (PBoC) was unique among central banks in the world’s biggest economies by not engaging in quantitative easing and other unorthodox monetary policies in the wake of the global financial crisis. Authorities in China fear macroeconomic instability, especially inflation, as an existential threat.
Some investors, such as Jan Dehn, head of research at London-based emerging market specialist Ashmore Group, believe CGBs could soon be seen as a safe haven, akin to Bunds, for both developed and emerging market investors.
There are some signs this may already be happening. The Citigroup World Government Bond Index has fallen 1.4% this year and the JPMorgan EMBI+ index is down 6%. The yield on 10-year CGBs has fallen by around 20 basis points.
Dehn believes the dominant narrative on China is wrong and recent developments should be seen as a signpost to the future.
“It’s like China is the Death Star: this threatening and inscrutable object that only bad things emanate from,” he says. “There’s going to be a hard landing or overheating or it is drowning in debt. None of these have come to pass. SDR inclusion and being added to indices is a process of global financial integration. There is a huge prize here that Xi Jinping is focused on: China eventually eclipsing the US as the global financial hegemon.”
China still has a long road to travel in terms of integration into the financial system. At the level of technical nitty-gritty there are even potential obstacles to bond index inclusion. China has a proliferation of regulators and ways to access its markets, and bond settlement is not true delivery-versus-payment.
This might stop Ucits (Undertakings for Collective Investment in Transferable Securities) funds participating, for example. But few believe the authorities will risk index inclusion by not ironing out these teething problems. In the meantime, investors are faced with the challenge of how best to incorporate China into portfolios.
The Chinese undoubtedly view inclusion into the main global bond indices as befitting of its status as the third largest bond market in the world, just behind Japan with an economy three times larger.
But emerging market index inclusion means these investors will also need to have a view. The role CGBs are likely to play in portfolios will be very different for these diverse investor groups.
The current yield of 10-year CGBs of 3.64% makes them a relatively high-yielding opportunity for global investors still grappling with large parts of their bond markets (Bunds, JGBs) offering very unattractive rates of return. For EM money managers, CGBs are low-yielding and rather dull compared with the likes of Brazil.
“If you look at global bond markets, there are very few opportunities where you are being rewarded for holding a reserve currency,” says Pierre-Yves Bareau, managing director and head of emerging market debt at JPMorgan Asset Management, which manages $1.7 trillion. “For relatively conservative investors, China will be an attractive opportunity as it is a way of extracting carry and the renminbi offers a diversification opportunity for investors holding a lot of dollars and euros. There is a mismatch between current allocations and the opportunity China represents.”
“It is inevitable that big global asset allocators will be looking at China ahead of index inclusion,” says Stephen Chang, executive vice-president and portfolio manager, Asia, at $1.7 trillion bond specialist Pimco.The diversification benefits of CGBs are big for developed market portfolio managers, including reserve managers, who have already been big buyers following the renminbi’s 10.6% SDR weighting. Index inclusion will bring a new investor base.
For EM investors, CGBs offer a different sort of opportunity, but one that is equally attractive. If China is included in JPMorgan’s EM indices, its sheer size dictates it will be at the maximum 10% weighting. Ashmore’s Dehn believes China will change the investment landscape for EM money managers by offering a safe haven in times of EM crisis.
The correlation between China and other EM local currency bonds has risen from zero in the early to mid 2000s to around 25% today. However, Dehn says that during bouts of EM risk aversion accompanied by sharp falls in prices, such as the global financial crisis in 2008, the European debt crisis in 2011 and the EM bond bear market between 2013 and 2015, correlations fell.
“If investors had access to China during these periods, there would have been a safe haven within EM,” says Dehn. “It would have provided an opportunity to reallocate within EM, rather than the binary decision to be either in or out of the market.”
For JPMorgan’s Bareau this low correlation has a theoretical underpinning.
“The history of EM has always been that when the Fed starts to raise rates EM suffers,” he says. “China can put in place countercyclical policies. To some extent we are seeing this currently. Rates have rallied in China, which shows the diversification benefits. There are not many EM countries that can put in place countercyclical policies, and that is particularly true of high-yielding countries such as Brazil, which make up a significant portion of EM index weightings.”
Correlations, however, are notoriously unstable. The low correlations exhibited by CGBs might also be explained by the lack of foreign participation in the markets. If CGBs became a mainstream holding in global bond portfolios, you might expect correlations to rise. For example, if US bond yields have risen sharply and Chinese yields have fallen, a global money manager might choose to take profits in CGBs and recycle them back into US treasuries. That would argue for buying CGBs now ahead of index inclusion.
A more immediate concern for investors has been the recent performance of the renminbi. It posted its largest ever monthly fall against the dollar in June and traded at a 19-month low in August.
“The recent moves in renminbi are interesting from the standpoint of correlations,” says Pimco’s Chang. “It might suggest that the low beta China has exhibited with the rest of EM in the past might not be true in the future.”
Fund managers offer a range of explanations, although none believe this is a deliberate attempt by China to manipulate the renminbi or a retaliatory move against Trump’s tariffs.
“I think it is simply about fundamentals,” says Chang. “There are a few things that have added to the pressure for the renminbi to depreciate: there is growth convergence; the US is growing quickly and China is slowing; the interest rate differential is also converging and that may continue for a while. It’s all about market forces.”
Aberdeen Standard’s McCabe believes the renminbi is playing catch up after a period of strength in the first half of the year while other emerging market currencies were suffering. He says: “If you look at renminbi in terms of its trade-weighted basket, all this recent weakness really represents is a mark to market.”
Whatever the short-term catalysts, in the longer term, investors believe there has been a shift in policy toward the renminbi that reflects China’s broader economic agenda. The export-led growth model that China pursued so effectively in the 20 years prior to 2008 meant that the level of the renminbi was the most important lever. As it shifts to an economic model driven by domestic consumption, it is allowing market prices to prevail across the economy, including interest and exchange rates.
As it manages this transition, however, it will continue to intervene to ensure broad macro stability. A weak renminbi is not in the authorities’ interest as there is a risk of capital flight, a lesson learnt in 2015.
“The renminbi is no longer pegged as was the case up to 2008,” says Ashmore’s Dehn. “The authorities will tolerate greater volatility against the dollar, but only to the point that it does not start to cause capital flight. They still have $3.1 trillion in reserves, so can intervene.”
The stability of the renminbi matters as most global investors currently view China as a rates and currency play. Index inclusion will not change that. Other than CGBs, Bloomberg only intends to include the three policy banks – China Development Bank, the Agricultural Development Bank of China and the Export-Import Bank of China – in its index. Overseas participation in Chinese credit markets is a paltry 1.7%
Aberdeen Standard’s McCabe describes the Chinese credit markets as being “in a state of flux”.
So far this year 18 companies have defaulted, representing almost $6 billion in payments. Defaults are on course to set a new record in 2018. Like much else that happens in China, this reflects policy.
“China is going through a deleveraging process with the authorities looking to medium-term financial stability,” says JPMorgan’s Bareau. “That is not a good time in the cycle to be heavily exposed to credit. The trade for us has been govvies.”
How this deleveraging process works out will be central to the future of credit markets.
Emil Nguy, founder and chief executive officer of Income Partners Asset Management in Hong Kong, has been investing in Asian bond markets for more than 25 years. He believes what is currently unfolding is “a self-engineered deleveraging, not, as it is sometimes portrayed, a re-run of the 2008 western financial crisis being played out in China.”
“Capital markets did not exist in China,” explains Nguy. “There was only the banking system to fall back on. In addition to loans, they improvised – creating SPVs [special purpose vehicles] using the deposit base of banks. That in very simplistic terms is what the shadow banking system is.”Nguy puts deleveraging in an historical perspective. In 2008, China was faced with a huge drop in demand for its exports. It responded with a massive fiscal stimulus, equivalent to 12.5% of GDP.
Nguy believes there has been some misallocation of capital and even outright fraud. However, he does not agree with more pessimistic assessments that this accumulation of debt will precipitate a crisis or tip China into recession. In May 2015, Beijing imposed a municipal bonds-for-debt swap, effectively creating a new market overnight. This process of amortization continues as a way of buying time.
“Time is a great healer, particularly when you have growth rates of 6%. That is the solution. So far I will give them a B+,” says Nguy. “It is another example of why the development of capital markets is so important and so is the education of investors. Historically there has been no credit culture because there was no history of defaults. That is why they are allowing defaults now. I see it as a positive thing. There’s an opportunity, if you have credit skills.”
Pimco’s Chang also sees opportunity in the current credit turmoil.
“Chinese high-yield bonds have performed terribly, but if you have skilled analysts, there is quite a bit of value now to be uncovered,” he says. “There are a few issues with some industrial names and SOEs [state-owned enterprises] but there are also a number of gems in the wreckage that we are looking at with keen interest.”
The problems in Chinese credit markets and the opening of CGBs to foreign investors are in some ways two sides of the same coin. Although the initial response of the authorities to the global financial crisis was probably a panicked overreaction (the hangover is thumping now), they quickly realized what the ramifications of a debt crisis in the West would mean. It was the end of an era of debt-fuelled consumption.
If China was to continue to grow at 6% or more, its economic model had to change. Boosting domestic consumption is now the focus. That implies a higher level of imports and running a current account deficit that needs to be financed by global financial flows.
“Rebalancing means that you need to attract capital and that means developing capital markets,” says Bareau. “A well-functioning bond market is central to that. Ultimately, this will also mean further reform, opening the economy and the capital account.”
SDR inclusion is another piece of the same puzzle. If a country is dependent on foreign capital flows, it matters whether the currency is the Malaysian ringgit or US dollar. In times of crisis, investors seek out safe havens, and reserve currency status is the passport. Dehn sees the exorbitant privilege enjoyed by the dollar since the Bretton Woods agreement in 1944 through the lens of the global financial crisis.
“Think about going to a party, getting properly drunk and driving home. You crash the car. That is what happened to the US in 2008. A debt-fuelled consumption binge funded an asset bubble so extreme it almost destroyed the entire western financial system. What happened in 2008? Everyone wanted dollars. It’s like the police turn up at the crash scene and hand you the keys to a new red Ferrari. That’s what premier reserve currency status is. It’s incredibly powerful, incredibly valuable and China wants it. Who wouldn’t?” asks Dehn.
|Emil Nguy, Income|
Joining the SDR was the first battle. It gave China the official imprimatur of the IMF. But ultimately Income Partners’ Nguy believes the fight for reserve currency status on a par with the dollar will be won and lost on the battlefield of trade. Japan was once an economic darling. But when the US reached saturation point in terms of providing vendor financing, it negotiated the Plaza Accord in 1985.
The appreciation of the yen from ¥239 to ¥128 against the dollar in just three years was arguably the main trigger for Japan’s lost decades of deflation. The yen made up 18% of the SDR basket in 2000 and is just 8.33% now, barely more important than sterling. Nguy believes China will not fall into the same trap.
“I look at this metric,” says Nguy. “The US is around 22% of global GDP, but the dollar accounts for around 70% of trade settlement. The GDP of the euro and its trade settlement use is approximately the same; 25%. It has a trade bloc. When people ask me what One Belt and Road is about, there is a simple answer: China wants its own trade bloc, something Japan never achieved. Add to that China’s huge natural resource demand and you have a significant trade bloc.”
Nguy expects a multi-polar reserve currency system to emerge between now and 2028, with China vying with the US as the preeminent reserve currency, while the eurozone, if it survives, maintaining between 20% and 25% of trade settlement. The development of a Chinese trade bloc will both cement China’s reserve currency status and provide a ready source of funding for its bond markets.
China already runs a trade deficit with the rest of the world except the US and eurozone. As its shifts to consumption that deficit will grow.
“If you are the central bank in a resource-rich emerging-market economy running a trade surplus with China and that trade is settling in renminbi, what do you do with the renminbi? You recycle it back into CGBs,” says Nguy. “This is happening already. [In July] it was announced that Russia was the biggest buyer of CGBs.”
Central bank reserve managers are likely to be a great source of demand for CGBs. EM central banks account for 80% of all reserves in the world. The IMF’s latest Currency Composition of Official Foreign Exchange Reserves report suggests both they and their developed market counterparts are still very long dollars, with little increase in diversification in recent years.
China certainly has scope to increase the issuance of CGBs and will need to in order to fund the current account and fiscal deficits of the near future. Although there has rightly been a lot of focus on China’s unprecedented increase in its overall gross domestic debt burden after the financial crisis, from 171% to 299% of GDP, according to the Institute of International Finance, the sovereign debt to GDP ratio is only 48%.
If it can manage deleveraging there is still scope for fiscal expansion, something that is not true in the post-financial crisis West. The biggest current source of CGB demand is from domestic savers and institutions. China has a savings ratio of 50%, and despite concerns about some leveraged financial products dreamt up in the shadow banking system, 90% of that wealth is still locked away in bank deposits.
Across Asia, 65% of wealth is held in cash, according to Boston Consulting Group. In Europe, the figure is 37% and it is just 14% in North America. A report by Northern Trust expects mutual funds and insurance to grow fivefold by 2025, which would make China the second biggest mutual fund market in the world. China is already the world’s second biggest market for non-life insurance, but the industry is still in its infancy. According to Swiss Re, floods along the Yangtze River basin in 2016 caused economic losses of $22 billion. Insured losses were just $400 million
Nguy compares the current state of development of China’s savings and investment markets with the US in the 1950s.
“There will be an accelerated pace of development from here, and I would expect in 10 or 15 years to see big domestic saving pools, large insurance companies and pension funds,” he says. “To service them there will be several $1 trillion asset managers, Asian Pimcos and BlackRocks.”
Aberdeen Standard’s McCabe saw a similar trajectory of domestic savings growth at first hand in Korea.
“When I first worked there, the only buyers of bonds were banks and they wanted zero to three-year paper,” he says. “As pension and insurance products grew, that changed. To minimize their duration mismatch these rapidly growing institutions bought up every long-dated asset they could lay their hands on.”
The deeper integration of China into the global financial system will see it open its current account. “It’s a carefully stage-managed process,” says Ashmore’s Dehn. “At some point the amount of money that wants to leave is in equilibrium with the money coming in; and at that point capital controls are abolished and you have a fully freely floating exchange rate.”
If all that sounds too good to be true it is perhaps worth remembering that China has already managed a remarkable economic transition.
“The long-term planning that exists in China makes it a very different market from an investment perspective than the US or UK,” says McCabe. “There is no electoral cycle to worry about and policy is directed toward execution and delivery. No one can doubt they have delivered so far.”
Above all China has an enviable track record for macroeconomic stability. Even in 2008, growth remained above 6% and has stayed there since. Over the last decade, inflation has averaged 2.35%. Inflation is a primary concern. Most historians believe that the Tiananmen Square protests in June 1989 were in part triggered by soaring inflation – it is something Chinese authorities are acutely aware of.
“CGBs do reflect different forces to other large bond markets and one is that the PBoC is an inflation fighting central bank,” says Pimco’s Chang. “They definitely want to keep inflation in check and have more measures to control inflation other than the interest rate, including exchange rates.”
An orthodox central bank is supported by a government conscious of its new role in the global financial and political system.
The US Federal Reserve does have an inflation target and will soon be fighting the fire caused by Trump’s fiscal stimulus pouring fuel on a late cycle boom. But when inflation did get out of control in the 1970s, the results were disastrous for asset holders. Between 1967 and 1977, the 20-year US treasury returned -1% and equities -31.4%. There were few places to hide.“The Chinese ultimately view the US retreat from free trade, ambivalence toward Nato, abandonment of responsible fiscal policy and build up of debt as helpful to what they want to achieve,” says Dehn. “So Xi goes to Davos and talks about free trade and the Paris climate agreement. He is portraying China as a responsible global citizen. He is playing a long game.”
CGBs are a new asset class for many global investors. But they have characteristics they may learn to love. Ashmore’s Dehn thinks it is not a stretch to believe they could play a role in portfolios similar to Bunds when German monetary policy was under the sole charge of the inflation hawks of the Bundesbank. For ‘Weimar’ read ‘Tiananmen’.
“The reason Germany is the economic powerhouse of Europe is because it used the money from the Marshall Plan very sensibly,” says Dehn. “Germany was solutions-oriented, had a responsible economic policy and they had the Bundesbank. China today is very similar.
“Investors should have a material allocation to Chinese bonds. They offer yield, low correlations and low volatility, backed by a central bank that cares about inflation and a government that has its eyes on the enormous prize of renminbi internationalization and the eventual eclipse of the dollar.”