Liberalisation pays: China’s bond market hits a sweet spot as the yuan and stocks sag
Nicholas Spiro says the gradual opening of the Chinese bond market has proven to be a bright spot for the economy as downward pressure from the trade war weighs on other economic indicators
The strain on China’s financial markets is increasing with each passing week. Last Wednesday, the yuan suffered its steepest daily fall against the US dollar since January 2016, according to data from Bloomberg. The currency’s 50-day moving average breached its 200-day equivalent for the first time since the surprise August 2015 devaluation, triggering a bearish technical pattern known as a “death cross”.
The selling pressure in China’s stock markets also shows little sign of easing. The Shanghai Composite index remains in bear market territory, down slightly more than 20 per cent from its peak in late January, compared with a 2.5 per cent decline for the benchmark S&P 500 index.
While the escalating trade conflict between Washington and Beijing is fuelling the deterioration in sentiment, mounting concerns about the slowdown in China’s economy and the adverse effects of a trade war on the country’s dwindling current account surplus are adding to the pressure on the yuan.
Yet, while China has again become the focal point of investor anxiety, it is proving extremely resilient in the most important and closely watched part of the markets.
At a time when developing economies are suffering heavy outflows of foreign capital from their local bond markets – redemptions have reached more than US$11.5 billion since the sell-off gained momentum in mid-April, according to data from JPMorgan – China’s US$12 trillion onshore debt market, the world’s third-largest, has been attracting huge inflows.
Despite last month’s sharpest fall in the yuan against the dollar since the inception of China’s foreign exchange market in 1994, foreigners stepped up their purchases of the country’s local bonds, according to Bloomberg.
Separate data from JPMorgan show that net inflows into China’s domestic government debt market in the first five months of this year surged to US$45 billion, in stark contrast to 2015 when inflows for the entire year plunged to just US$13 billion, down from US$44 billion in 2014.
Make no mistake, China’s local bond market is an anchor of stability. What is more, it has entered a sweet spot from both an external and domestic standpoint.
The liberalisation of China’s bond market over the past several years, notably its inclusion earlier this year in the Bloomberg Barclays Global Aggregate Bond Index (one of the leading global bond gauges), has led to a marked increase in foreign holdings of local bonds, allowing passive funds that track indices to gain access to China’s debt market. According to Bloomberg, foreign holdings have surged from 800 billion yuan (US$119.5 billion) early last year to nearly 1.4 trillion yuan.
Not only has increased foreign participation in China’s debt market helped allay fears about capital outflows, the gradual pace of liberalisation, coupled with the sheer size of the market, mean that non-resident holdings still account for just 2 per cent of outstanding yuan-denominated bonds.
This makes China less vulnerable to outflows of foreign capital compared with emerging markets with much higher levels of foreign ownership of local bonds. In Malaysia, Indonesia and South Africa, foreigners hold between 25 and 40 per cent of local government debt.
From a domestic perspective, China’s bond market is being buoyed by expectations that the escalation in trade tensions between the United States and China will increase the scope for looser monetary policy, particularly given the recent economic slowdown.
Last month’s decision by the People’s Bank of China not to follow the Federal Reserve in raising interest rates and instead announce a further cut in the reserve requirement ratio for large commercial banks suggests that the trade conflict is forcing policymakers to prioritise growth over deleveraging.
The perception on the part of bond investors that China’s policymaking regime is becoming more growth-supportive is helping assuage concerns about the effects of the sharp fall in the yuan, which ought to be reducing foreign demand for domestic debt. Instead, investors are, at least for the time being, treating the currency’s decline as part of a shift to looser financial conditions that will benefit local bonds.
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Still, stronger foreign demand for onshore debt is not without risk.
The surge in foreign inflows has helped reduce the yields on local bonds, which have already fallen significantly due to earlier measures to loosen monetary policy. China’s 10-year bond yield has dropped 50 basis points since mid-January, to 3.5 per cent, narrowing the gap with equivalent US Treasury yields to just 70 basis points.
This has reduced the appeal of Chinese debt compared with some other leading emerging markets with much higher yields.
However, China’s domestic bond market is a colossus and is just beginning to open up. Provided policymakers can avert a 2015-type crisis, the sweet spot should endure for some time.
Nicholas Spiro is a partner at Lauressa Advisory