Why China is investing in US bonds

What the opening of China means for bond investors

Starting from a local market that was initially completely closed off, the Chinese administration, which is still keen on absolute control, is taking small steps on a long way to possible full liberalization. In the future, the economic model, which was formerly based on production and export, with an unfree money and capital market and rising prosperity, is to be converted to more domestic consumption with a strong service sector.

In the past, it was possible to build up enormous foreign exchange reserves via the trade and current account surplus, which made China a net creditor vis-à-vis other countries. The local market is buffered by the savings that are practically caught domestically. Chinese households have the highest personal savings rate in the world at 25 percent, and the national savings rate is even higher at an unbelievable 46 percent.

In view of the negative historical experiences of emerging countries that have already opened their local markets to the outside world, for example the Asian crisis in 1998, the Chinese decision-makers have so far avoided the so-called boom-and-bust cycles. These episodes of fluctuating strong capital inflows and outflows severely damaged the economic development of the countries concerned.

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In the past, foreign funds could not be freely invested in China, nor could domestic capital flow out of the country. However, in recent years, investor access to the Chinese local bond market has become much easier.

Until not so long ago, international investors had to go through lengthy, complicated and costly approval processes in order to be able to settle scarce Chinese government bonds with the associated local market risks on site via the clearing house.

Second largest bond market after the USA

It was only with the introduction of the Bond Connect program in 2017 that foreign investors were given direct, license-free access to Chinese government bonds via the Hong Kong stock exchange. This laid the foundation for local Chinese bonds to meet the requirements for inclusion in indices. After the Barclays Global Aggregate Bond Index added Chinese bonds with a weight of six percent in 2019, both FTSE with the World Global Bond Index and J.P. Morgan follow suit with their indices.

With a value of more than 13 trillion US dollars, Chinese government bonds are now the second largest local market in the world after the USA. This also corresponds to their economic share of around 20 percent of the world economy.

Due to the current access restrictions, foreign interest rate investors only own around 2.5 percent of the Chinese bond market and are suddenly massively underweight. During the ten-month admission phase of Chinese bonds to J.P. Morgan indices are built up one percent per month until the maximum target weight of ten percent is reached. This alone is expected to generate inflows of US $ 250 billion to US $ 300 billion into Chinese government bonds.

First of all, the inclusion of Chinese government bonds in the J.P. Morgan Government Bonds Index for emerging market bonds. In its global, diversified version, the index is considered the benchmark of the financial industry for mapping the asset class bonds in local currencies. Nevertheless, with only 19 countries included and a maximum weighting of the major markets of ten percent, the index is still very risk-clustered. The inclusion of China with a share of ten percent changes relatively little in the weighting of the top 5 with a total of 47.7 percent (previously 48.2 percent) or the top 10 with a total of 80.9 percent (previously 81.7 percent).

In order to make room for the new heavyweight China in the index, the weightings of other countries such as Thailand, Poland, South Africa and Russia will be reduced by around one percent. Smaller countries like Hungary, the Czech Republic or Turkey are reduced by half a percent. In contrast, the inclusion of Chinese bonds has little effect on the other bonds from Brazil and Mexico, which are at the upper limit of ten percent. The same applies to the minimally weighted small index participants Philippines, Dominican Republic and Uruguay. Often providers even omit these index participants entirely because their weighting of less than one percent can be neglected.

The creditworthiness with the A rating, which is rated as relatively good by the market, means that the average credit quality of the index improves with its current average of BBB. China's national debt was recently at a comparatively moderate 50 percent of gross domestic product, with the majority being held domestically and only 13 percent of GDP accumulated in external liabilities. Due to the administrative control, the deep and highly liquid Chinese bond market still fluctuates relatively little compared to the completely free markets of other emerging countries. As a result, volatility and the risk of illiquidity are also reduced at the index level.

Along with the feeling of security that has been gained, however, the annual return on maturity of the index falls, as Chinese bonds offer a return of less than three percent compared to the current index average of around five percent. For active asset managers who are not or only slightly based on the specifications of an index, this offers better opportunities to achieve outperformance, i.e. higher returns.

China's inclusion in the index comes at a time when investors need to enter the market at rather high levels. As the following graphs show, the annual yield on bonds is currently already below the long-term average. The premium is only relatively low, especially when you consider the exchange rate risks - especially since the Chinese yuan has already appreciated after the preliminary settlement of the trade dispute with the USA. Despite the dramatic course of the corona crisis, the currency has so far been largely spared the economic consequences of the development, but not the bond yields, which have continued to fall. This is because monetary policy easing in interest rates and liquidity was implemented to provide support. The expected capital inflows will worsen both trends to the detriment of index investors.

Control of the exchange rate

The default risks of Chinese government bonds appear to be rather low, based on their credit rating and historical price fluctuations. Nonetheless, the risk of capital losses for foreign investors remains in the event of currency devaluation.

So far it has been China's policy, when its own export goods become more expensive due to the imposition of new tariffs, to compensate for exactly the same amount through competitive currency devaluations. Calculated in hard currency, the goods for the importer remained practically at the same competitive price level. Since the trade dispute is expected to remain an issue after this year's US presidential elections, a devaluation of the yuan is not unlikely.

What is also unclear is the future of the internally locked savings of the increasingly affluent Chinese population. If there is liberalization here too, money will flow from China to other countries. This could put further pressure on the Chinese yuan.

Inflation in China is currently more than five percent, which in turn pushes the real return, i.e. the difference between interest and the inflation rate, clearly into negative territory.

Such a scenario is fundamentally not conducive: if inflation rises and bond yields are kept artificially low, further devaluation pressure arises on a currency.

Opening the Chinese bond market to foreign investors is an important step in the development of the capital market. Because Chinese government bonds are included in various bond indices at the same time, a strong flow of capital is to be expected, especially from institutional buyers. Compared to other emerging markets, however, the expected maturity yield on local bonds is at the lower end of an already very low level. Active asset managers can use their leeway and purchase bonds in Chinese yuan that have been issued under international law and have a more attractive annual maturity yield. In addition, it will be interesting to observe how the higher capital flows will affect the control of the exchange rate of the Chinese yuan that has been practiced up to now.

More on the subject:
Above all, the stock exchange offers long-term opportunities for investors. This is also shown by the conservative and speculative model portfolio in our BörsenWoche financial letter. And there are risks: you can find out why you should never bet against the central bank, for example, in issue 258 of BörsenWoche.

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