China’s government bond market has charted a rapid rise over the past two decades on the back of robust economic growth.
The asset class has also made considerable strides to integrate into the global financial system in recent years. FTSE Russell announced in September that they would be including Chinese bonds in its World Government Bond Index (WGBI), following earlier decisions by Bloomberg to include China in its flagship Bloomberg Barclays Global Aggregate Bond Index – and JP Morgan in its Global Bond Index Emerging Market (GBI-EM).
Foreign ownership of Chinese government bonds has reached approximately US$230 billion, representing 9% of the Chinese government bond market, according to China Central Depository & Clearing (CCDC).
We believe foreign fund flows will accelerate both to account for the index inclusion changes and also to take advantage of the asset class’s low beta duration characteristics and diversification benefits. Going forward, we expect foreign fund flows could reach US$120 billion in 2020 and around US$100 billion per year thereafter.
The RMB-denominated Chinese government bond market, defined as central government bonds, has grown more than four-fold over the past 15 years, representing a total market size of approximately RMB 18 trillion (US$2.7 trillion).
We expect this opportunity set will continue to grow in both depth and breadth, especially given that China’s economy has managed to record sustained growth even amid the coronavirus pandemic. Notably, the IMF forecasted that China will be the only major economy to record positive growth in 2020 followed by a robust 8.2% expansion projected for 2021.
After shifting to a consumer-led growth model following decades of rapid expansion, China continues to establish new ambitious economic development goals. Without providing specific numerical targets, President Xi Jinping said that it was possible China could match the standards of a so-called high-income country by 2025 and double the country’s per capita income by 2035.
In our view, there are still significant growth opportunities but policymakers will need to pay close attention to rising debt levels and ageing demographics, as well as drive further rebalancing in the economy.
Because of its capital controls, China has historically been a difficult market to invest in for global investors. This has changed in recent years, however. China has implemented a number of measures to improve access to its fixed income market via its Bond Connect programme through which foreign investors can invest in Chinese bonds through links between Hong Kong and Mainland financial markets.
Authorities have effectively handed over a certain amount of control of its capital markets to overseas investors, allowing them to sell their positions. It might even be possible for investors to short Chinese bonds once a functioning futures markets is accessible.
Monetary authorities continue to exercise monetary policy through interest rates and bank reserve requirement ratios (“RRR”) along with interest on excess reserves rate (“IOER”), while moving to provide ample liquidity to the market through open market operations and short-term liquidity facilities when necessary.
With China pushing for broader international use of the renminbi, the Chinese government and the People’s Bank of China (PBoC) has worked extensively to enhance and strengthen the country’s bond market. The PBoC has also engaged in joint research with the International Swaps and Derivatives Association (ISDA) to promote RMB-denominated bonds as collateral for derivative transactions.
In terms of the local currency component of Chinese government bonds, the renminbi floats in a narrow margin around a fixed base exchange rate determined with reference to a basket of world currencies. The Chinese Foreign Exchange Trade System (CFETS), run by the PBoC, sets the base rate based on previous day closing prices at domestic banks.
In October, CFETS announced the phasing out of the “counter-cyclical” factor used to adjust the base rate, allowing exchange rates to fluctuate more with the market and adding transparency to renminbi pricing. This is also likely to be a move to enhance international recognition of China’s currency.
Investors should consider how adding Chinese government bonds could potentially result in a more diversified portfolio capable of achieving consistent returns. The asset class offers a higher yield than the broader WGBI benchmark along with a lower duration – an attractive expected risk return profile.
Furthermore, the PBoC has its own interest rate cycle and operates under different dynamics from the Federal Reserve and the European Central Bank, giving these bonds uncorrelated characteristics to developed government bonds.
As for the currency component of Chinese government bonds, while heightened US-China tensions may add to temporary volatility in the currency market, the interest rate differential against developed currencies and China’s current account surplus should support the renminbi.
The Chinese government bond market has grown in both depth and breadth, while also achieving inclusion into global benchmarks. Foreign fund flows into this market should continue to accelerate, eager to capitalise on the asset class’s attractive risk-adjusted return profile and diversification benefits.
Over time, the opportunity set within the asset class will likely further expand, favouring strategic investors who can make effective allocation decisions based on an extensive macroeconomic research process along with an informed understanding of the market’s evolving capital controls.
Leonard Kwan is Portfolio Manager, Emerging Markets Fixed Income at T. Rowe Price