China’s bonds offer good yields, liquidity and size...so why do foreign investors avoid them?
China undertook another major step towards liberalising its capital market this week, with the official launch of the China-Hong Kong Bond Connect.
Following the 20th anniversary of Hong Kong’s return to Chinese rule, the People’s Bank of China and the Hong Kong Monetary Authority jointly announced the launch of the programme this week, with the trial operation effectively starting on Monday.
The Bond Connect is the third capital market link that bridges the onshore and offshore markets. Like the two equity link programmes that opened the A-share market to the world, the Bond Connect will significantly improve foreign investors’ access to the world’s third-largest bond market in our view.
Compared to the existing channels of investment – the qualified foreign institutional investor/renminbi QFII and the China interbank market direct schemes – the Bond Connect presents a more efficient route of market access from trading, settlement and custodian arrangement perspectives. Clearing these operational hurdles will make yuan bonds more attractive to foreign investors. We think the connect scheme has the potential to significantly lift foreign investor participation in the onshore bond market from the current level of less than 2 per cent.
Fundamentally, yuan bonds are in our view an attractive investment to global investors from the perspectives of valuation, yield, liquidity and size. China, as the world’s third-largest bond market, has the scale and liquidity to accommodate large investment flows. The central government bonds are highly rated (AA-minus by Standard & Poor’s) and carry a 3.5 per cent yield (at the 10-year tenor). Its abundant supply, about 12 trillion yuan currently, can help alleviate the global shortage of safe-haven assets while still offering investors a decent rate of return. The latter could be important for investors in this day and age of zero or negative interest rates.
With all these fundamental attractions, why have foreign investors not embraced yuan bonds en masse already? There are three broad reasons in our view.
First, the onshore bond market has, until very recently, been shut out of the global capital market. Even if foreign investors wanted to share in China’s growth, their means of market access has been severely constrained by the country’s closed capital account.
Second, yuan assets – both bonds and equities – have not been included in global benchmarks (until last week’s MSCI announcement), meaning investors were not obliged to invest in the Chinese market. Without a place in the global indices, not only has China missed trillions of passive index-tracking funds, but also active investors have no incentives to invest, given the unattractive cost-and-benefit trade-offs (eg. losing money will be blamed more severely than rewards for making money).
Finally, some investors have avoided Chinese assets due to their concerns about the economy. The latter has manifested itself, in recent years, in slowing growth, rising economic imbalances and a lack of progress in some structural reforms. Rising market volatility, combined with foreign exchange depreciation, has scared some investors away, resulting in a tepid reception to some of China’s recent liberalisation moves. In fact, China has experienced mostly net capital outflows over the past two years.
Overcoming these challenges will be critical for China to ensure smooth liberalisation of its capital market. While resolving all of them is not easy, tangible progress has been made incrementally.
On market accessibility, various connect schemes have helped tear down capital controls, making the onshore market more open and accessible to foreign investors. Progress on index inclusion is also evident, with the yuan entering the International Monetary Fund’s special drawing rights basket in 2016 and A shares winning the bid for the MSCI inclusion just last week. We think the launch of the Bond Connect will drive active discussions of bond inclusions in the near future.
Finally, the recent stability in the Chinese economy has revived investors’ interests in yuan assets. The positive investor sentiment has been reinforced by the strengthening of the yuan exchange rate and more balanced flows in the capital account.
However, to fundamentally turn investors’ sentiment on Chinese assets, more tangible reforms are needed to remove structural imbalances and set the economy onto a more sustainable path. We are hopeful that such changes are forthcoming following the leadership transition later this year.
Overall, we see the bond and equity connects as important prerequisites for integrating China’s capital market into the global financial system – a process that, we think, will bring profound changes to the world. For China, such an integration is an inevitable part of its long-term economic and financial development. But there will be rough sailing in certain episodes of this prolonged transitioning process, which will require the local players, including investors and regulators, to learn, adjust and adapt to the new rules of the game.
Aidan Yao is senior emerging Asia economist at AXA Investment Managers