Is that issuer from Hunan or Henan; Shanxi or Shaanxi? Pity the poor fund manager sitting at his desk in the American heartlands. After years of needing to know very little about the $13 trillion Chinese bond market, the day is getting closer when that is going to change.
This week (on April 1) Bloomberg included China in three of its bond indices for the first time. The most notable is the Bloomberg Barclays Global Aggregate Index (BBGA), which has $2.5 trillion in assets following it. Over the next 20 months, Chinese bonds will see their weighting increase in monthly increments to 6.03% of the benchmark.
That figure looks fairly manageable – equating to foreign institutional fund inflows of up to $150.8 billion, or roughly 1.5 times the net inflows into Chinese bonds during 2018. However, this does not take into consideration factors that could make overall inflows into China’s bond market a whole lot greater.
First, there is the accelerator effect, including the fact that central banks and sovereign wealth funds (SWFs) are only in the early stages of ramping up their bond holdings themselves. Over the last few years, they have been the main driving force among foreign buyers for Chinese bonds. This was particularly true in 2018 when foreign holdings nearly doubled to Rmb1.73 trillion ($257.5 billion). That amounts to 2.3% of the bonds traded on the bond market, according to People’s Bank of China (PBoC) figures.
A quick look at the outstanding holdings of yuan-denominated foreign currency reserves shows how central banks and SWFs are likely to plough considerable funds into Chinese Government Bonds (CGBs) over the next few years. It is still a mismatch in currency terms: at the end of last year, only 1.9% of the world’s $11.4 trillion foreign exchange reserves were held in the Chinese currency. By comparison, 61.7% were held in dollars, 20.7% in euros, 5.2% in yen and 4.4% in British pounds.
The growing participation of foreign fund managers, central banks and SWFs is going to set off a chain reaction. And beyond Bloomberg, other major index providers including FTSE-Russell, which owns the World Government Bond Index and JPMorgan, compiler of the Global Bond Index, are likely to start including Chinese bonds as well.
Moreover, China’s weighting in the BBGA isn’t likely to stay at 6.03% for very long. Some market specialists believe it could ramp up to 25% within the next three to five years. The first bonds to be included in the benchmarks are CGBs and policy bank bonds (from China Development Bank, as well as the Export Import Bank of China). The weightings don’t include any corporate debt, something that will change once the credit rating agencies are allowed to rate Chinese corporate bond issues.
Standard & Poor’s has already had its application to do so approved, saying that it will use China’s domestic standard, which assigns triple-A ratings to investment grade debt and double-A ratings to high yield debt.
Moody’s has said that it will do things differently by deploying its global standard, although its application to start operations in China is yet to get final approvals.
The steady increase in weighting of Chinese bonds will be unsettling for many of the world’s fund managers, who have yet to get to grips with CGBs, let alone the perils of Chinese corporate debt. Aside from a lack of knowledge about the market there is also the fact that the bonds can be hard to trade because the Chinese have their own clearing system that isn’t connected into global ones like Euroclear. And there are other drawbacks, including a lack of interest-rate derivatives that would allow for hedging by foreign investors, who are blocked from trading government bond futures as well.
All the same, HSBC’s co-head of markets for Asia Justin Chan thinks April 1 2019 marks another “important milestone” in the internationalisation of China’s bond markets. “For years, many global investors saw investing in China as interesting but too challenging – something for tomorrow, not today. But, with reforms and index inclusion, tomorrow has come,” says Chan.
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