Why China’s pandemic-induced rally is on solid ground, even as the US and EU flounder

Unlike the last global crisis, it is not China but the US and Europe that are the main shock absorbers for the world economy. While China’s debt is a concern, advanced economies’ over-reliance on ultra-loose monetary policy is a bigger one

Nicholas Spiro

Published: 3:30am, 18 Dec 2020

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Japanese pension funds have historically been regarded as the world’s most conservative investors. Yet, they were the driving force behind the record amount of Chinese government bonds bought by Japanese investors in the first 10 months of this year: US$5 billion, a 15 per cent rise compared with the same period in 2019, which itself was a bumper year, data from JPMorgan shows.

The increased appetite for Chinese debt on the part of traditionally risk-averse buyers is one of the most conspicuous signs of a regime change in markets since the Covid-19 pandemic erupted. The unprecedented virus-induced stimulus measures undertaken by the world’s leading central banks have crushed bond yields, and significantly widened divergences in policy between Western economies and China.

In stark contrast to previous global crises, when China did the heavy lifting to support growth, it is now the United States and Europe that are the main shock absorbers for the world economy. The immediate consequence is a dramatic widening in the gap in borrowing costs between the West and China, leaving the world’s second-largest economy as the only major market offering investors positive real interest rates.

The differential between the yield on benchmark 10-year US Treasury bonds and its Chinese equivalent has doubled since the start of this year to 240 basis points, turning China’s debt market into a magnet for yield-starved investors.

Moreover, China’s inclusion next year in the FTSE Russell World Government Bond Index has strengthened its bonds’ haven appeal, adding to their allure. The FTSE Russell index is one of the main gauges used by global bond investors, another being the Bloomberg Barclays Global Aggregate Index, which China joined in April 2019.

The post-pandemic surge in inflows – foreign investors bought a net US$130 billion in Chinese bonds in the year to date, compared with US$80 billion last year, data from JPMorgan shows – has contributed to a fierce rally in the yuan. It is currently at its strongest level against the US dollar since the trade war began in earnest in June 2018.

Although the plunge in the greenback is a key factor, the renminbi’s ascent is mostly attributable to the sharp increase in capital inflows. With Chinese stocks outperforming all other major global equity indices this year, foreign investors are pouring money into the country’s equity funds, despite persistent outflows from emerging markets.

While the rush for Chinese assets poses policy dilemmas for Beijing, which in the past few months has become more concerned about risks to financial stability, China’s economy and markets are likely to remain in a sweet spot for some time.

First, in a twist of fate, it is the country where the virus originated which has brought it under control far more effectively than any other leading nation, and whose economy has outperformed the rest of the world.

China’s strong V-shaped recovery, in a world full of W and U-shaped ones, is going from strength to strength, with industrial output and retail sales growing at annualised rates of 7 and 5 per cent respectively last month.

While the upswing in domestic demand still has some way to go, China’s recovery looks even more impressive when compared with the virus-induced devastation in Europe and America. Germany, one of the success stories during the first wave of the pandemic, has just imposed a hard lockdown that is likely to cause a double-dip recession.

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In the US, meanwhile, where the death toll exceeds a staggering 300,000, the resurgence of the virus has affected nearly every state in the country, causing the labour market to slow significantly, and fuelling concerns about a much sharper deceleration in economic activity.

Second, China’s relatively restrained government borrowing and monetary easing have helped redress the geographic balance of asset price distortions in its favour. A 10-year bond yield of 3.3 per cent is healthier and more normal than a yield of 0.9 per cent in the US, to say nothing of minus 0.5 per cent in Germany.

Although China’s economy is a state-led one and expanding at a much faster pace, the pandemic has accentuated a shift in investors’ perceptions of global policymaking and markets.

The scale of intervention on the part of central banks to control asset prices is now much greater in the West. China’s debt problems are still a big concern, but advanced economies’ over-reliance on ultra-loose monetary policy is a bigger one.

Third, while the recent spate of corporate defaults in China has accentuated vulnerabilities in the country’s debt markets, many investors view Beijing’s willingness to tolerate the market repercussions from missed debt payments by state-owned enterprises as a positive development.

Not only is it a signal from policymakers that investors should differentiate more clearly between companies, increasing the scope for risks to be priced more accurately, it suggests Beijing is determined to nip financial excesses in the bud.

While there is a danger that investors are becoming unduly bullish on China, markets are even frothier in the US and parts of Europe. China’s pandemic-induced rally has further to run.

Nicholas Spiro is a partner at Lauressa Advisory