Chinese bond momentum remains strong, but don’t expect the yuan rally to last
- Aidan Yao says a number of factors are supporting the bond market, including easing measures by the central bank and the bonds’ inclusion in the Bloomberg global index. By contrast, downside risks are likely to keep the recent yuan rally in check
The Chinese bond market got off to a solid start in 2019, building on the strong momentum from last year that saw China buck the global trend to deliver positive returns to investors.
Rather than simply adding liquidity, which is already abundant in the financial system, the authorities need to focus on unclogging monetary transmission to allow excess liquidity to flow to real sectors of the economy. The central bank bills swap, along with other recently announced measures such as the TMLFs, is aimed precisely at doing so.
Continued strong foreign inflows to China’s fixed-income markets further aided the bond rally. Part of these, particularly to the offshore credit market, were simply a reversal of the capital exodus from December. But, for the onshore market, the rising demand is, at least partly, driven by growing expectations that Chinese bonds will soon become part of the global fixed-income benchmarks.
To facilitate easier market access, the China Security Regulatory Commission has pledged to merge two programmes for investors – the Qualified Foreign Institutional Investor and Renminbi Qualified Foreign Institutional Investor schemes – and expand the availability of instruments (for example, margin financing, repurchase agreements, and over-the-counter market access) to foreign investors. These moves could help China win approval from other global index operators, such as the FTSE Russell and JPMorgan Emerging Market Bond Index, and extend the momentum of capital inflows in the year ahead.
In the currency space, the move has also given the renminbi a shot in the arm.
In January, the yuan appreciated 2.6 per cent against the US dollar and 1.6 per cent against its trade-weighted basket, according to the Bank for International Settlements, halting its losing streak since last June. The fact that the renminbi was among the best performing currencies last month, and has gained strongly in both nominal and real effective terms, suggest genuine strength in the currency, reflecting a shift in investor expectations.
However, whether this shift represents a change of direction for the renminbi remains highly uncertain. Indeed, with the Chinese economy still expected to lose steam, monetary easing to be stepped up further, and the current account to swing to negative, the fundamentals do not look good for an extended currency rally over the medium term.
Hence, caution is still warranted for the yuan. The balance of risks is still tilted to the downside, in line with our expectations of a treacherous path ahead for Sino-US economic relations.
Aidan Yao is a senior emerging Asia economist at AXA Investment Managers