The China Onshore Bond Market
In the 19th National Congress of the Communist Party of China held in 2017, President Xi Jinping said that “China will not close its door to the world; we will only become more and more open”1 . Two years on, the Chinese government continues to push out reforms and initiatives to open up its financial industry, including the bond market. A decade ago, foreign investors had limited access to China’s bond markets. Today, with greater liberalisation of China’s financial markets, limited access is no longer a reason for foreign investors to not invest in this market. The development and opening up of the China onshore bond market goes hand in hand with Renminbi (RMB) internationalisation - a policy which the Chinese government has been pushing since the late-2000s to promote trade and investment. RMB internalisation is a virtuous cycle, as it has been a catalyst for important reforms which include structural reforms, financial market liberalisation and an increased use of the RMB.
Structural Reforms - China’s Growth Transformation
China is large and its transformation is difficult to ignore. Its USD 13.4 trillion economy is one of the largest in the world, representing 16% of the world’s economy. At its current growth rate, China is forecasted to overtake the US by 2030 in terms of economic size. The Chinese government has committed to significant reforms as it transforms the country from an investment-driven economy to one that is consumer-driven. It continues to aim for a more balanced growth, switching from exports and manufacturing towards one that is led by more consumption and services. It is also moving towards higher value-added manufacturing and services, as well as reforming its state-owned enterprises to improve efficiency and capital allocation for the private sectors.
Chart 1: Size of Economy to Global GDP
Source: IMF, as at April 2019
Financial Market Liberalisation
Financial market liberalisation supports the efficient capital allocation within China’s economy. Bank credit is a form of indirect financing that remains a dominant source of financing to the non-financial private sector in China. The Chinese government aims to boost direct financing through the bond market, as it allows for price discovery and efficient capital allocation. This shift from indirect to direct financing with improvement in price discovery and efficient capital allocation is an investment opportunity. China’s financial market reforms covers the banking sector, asset management development and monetary policy progression. This has resulted in the development of the fixed income and equity markets, which in turn leads to deep and liquid markets, with product diversification catering to different investor needs.
Additionally, part of China’s financial market liberalisation is allowing for credit defaults to happen with no systemic fallout. This improves market discipline to price credit risks properly. Credit differentiation can be seen with ample liquidity onshore but high yield spreads compared to investment grade spreads remain wide. Although defaults have increased, the default rate remains lower than global averages as it started from a low base.
Chart 2: Capital Financing as a Percentage of GDP
Source: BIS, Bloomberg, WIND, as at July 2019
Chart 3: China Onshore Bond Defaults
Source: WIND, as at July 2019
Promoting the Use of the RMB
RMB internationalisation includes promoting the use of the RMB, which increases the currency’s attractiveness. The government has promoted the use of the RMB as a:
- Trading currency – payment and settlement for goods and services in RMB
- Investment and funding currency – attractiveness of RMB asset markets and cost efficiency of funding in RMB
- Reserve currency – Diversification for central banks
- Pricing currency – An alternative for the pricing of commodities
As a trading currency, the use of RMB has grown exponentially. The RMB is now the world’s fifth biggest payment currency, behind the US Dollar, Euro, Sterling Pound and Japanese Yen. However, the RMB is still underutilised versus its importance in trade, given that China is the second largest trade nation and is closing the gap with US in terms of net trade with the world. Even against the Euro, which contributes to about 34% of payments, the RMB still has room to grow. Also, China’s growing ties with Asia and the continuation of the Belt Road Initiative suggests that this trend is likely to continue.
As an investment and funding currency, China has gradually opened up its onshore equity and bond markets for foreign investors. From the development of the offshore renminbi (CNH) market, to limited institutional quotas, and currently to the less restrictive stock and bond connect access, foreign investors can now invest in the onshore capital markets, without limited restrictions which was in place a decade ago.
As a funding currency, international debt issuance in RMB has room to grow. Both the Belt and Road Initiatives financing and panda bonds - RMB bonds which are issued by foreign issuers in the onshore bond market - are live examples of RMB issuance.
Chart 4: Outstanding International Bonds
Source: Bloomberg, 1Q2019
Chart 5: Annual Panda Bond Issuance
Source: Bloomberg, as at July 2019
As a reserve currency, the inclusion of the RMB as the fifth currency in the IMF Special Drawing Rights basket in October 2016 was a significant recognition of the currency’s importance as a reserve currency to central banks globally. It still has a lot of potential to grow when compared to the current reserve allocation to the US Dollar and Euro. The use of RMB as a reserve currency will increase with more uses for RMB as a trade and investment currency. A 1% increase in RMB for reserve managers is about USD 107 billion based off total reserves as at end-2018.
Chart 6: Composition of Global Reserves
Source: IMF, 4Q2018
Chart 7: US and China Oil Imports
Source: Bloomberg, as at 31 December 2017
Additionally, given that China is one of the world’s largest oil importers, this is beneficial for the RMB as a pricing currency. In line with this, China launched the crude oil futures contract in Shanghai Futures Exchange in March 2018, with its average monthly open interest continuously rising. The increased use of RMB as a pricing currency suggests potential recycling of RMB from oil exporters into the China bond markets.
A Bond Market Too Large To Ignore
The China onshore bond market is large, with an outstanding size of about USD 9 trillion as at end June 2019. It is the third largest bond market globally after the US and Japan, with a diversified universe of issuers which includes governments, state-owned enterprises, financial institutions and corporations. Credit bonds make up about 50% of the RMB onshore fixed income market, with different products catered for different investor needs.
Chart 8: Outstanding Onshore RMB Bonds
Source: BIS, as at June 2019
Chart 9: Outstanding Bonds in Selected Markets
Source: BIS, as at 3Q2018
Accessing RMB bonds have evolved through the years as the Chinese government have liberalised its rules. Initial access to RMB assets was through the offshore CNH or Dim Sum bond market as foreign investor access into the more liquid interbank bond market through the Qualified Foreign Institutional Investor (QFII) was limited. As the rules for these quotas evolved, through the QFII, Renminbi QFII or a direct program into the China Interbank Bond Market, foreign investors gained further access onshore. The launch of the Bond Connect scheme in 2017 opened up the gates further. Unlike QFII or RQFII, the scheme allows eligible foreign institutional investors to buy bonds without a quota. Access to the onshore bond market continues to be refined and foreign ownership has a lot of room to grow given that it remains low at 3% of the total market.
Chart 10: Foreign Holdings of China Onshore Bonds
Source: BNP Paribas, Guide to 2019 Index Inclusions of Chinese Onshore Assets, 15 Jan 2019.
A large bond market like China would traditionally be a part of global bond indices. As foreign investor access was previously restricted, China onshore bonds were not included. With the market regulatory environment being made more accessible, Bloomberg Barclays has finally included China onshore RMB bonds into the Global Aggregate Bond Index starting April 2019. The phased-in inclusion will peak with about 5-6% estimated weight for China government and policy bank bonds. This inclusion signals the maturing of the China bond market. Inflows of about USD 295 billion is estimated from the potential inclusion of onshore bonds into the major global bond indices. The mix of foreign players will enhance market development and investment opportunity set. Currently, only government bonds and policy bank bonds are included in the benchmarks. Half of the market, which mostly comprises credit bonds, are yet to be included in the indices.
Table 1. Estimated Inflows into China Onshore Bonds from Index and Reserves Flows
Source: JPM, Barclays, Citi and IMF, as at July 2019. *Based on % of global GDP.
Table 2. Bloomberg Barclays China Aggregate Bond Index Characteristics
Source: Barclays Live, as at 28 June 2019.
China Onshore Bonds - Higher Yields, Lower Correlation, Larger Diversification
Against this backdrop, China onshore bonds can provide investors with relatively higher yields complemented by a long-term positive outlook on the currency. In a world of negative yields, China bonds provide relatively high yields compared to most of the developed bond markets. As shown in Chart 11, China government bond yields have been generally higher than most developed bond markets. Aside from higher yields, China bonds also provide additional diversification given lower correlations to the broader market as indicated in Chart 12.
Historical returns of China government bonds have shown a track record of outperforming the market despite bouts of RMB weakness. At the same time, volatility-adjusted returns have also shown to be better than developed markets.
Chart 11: Yield on 10Y Treasuries
Source: Bloomberg, as at May 2019.
Chart 12: Correlation of Treasuries to Global Aggregate
Source: Bloomberg, as at May 2019.
Chart 13: Government Bond Index Returns
Source: Bloomberg, as at July 2019. Returns are based off various unhedged indices.
Chart 14: Volatility-Adjusted Returns
Source: Bloomberg, as at July 2019. Vol-adjusted returns are based off various unhedged indices.
Summary – The Case for China Bonds
Continuing RMB internationalisation coupled with the opening of China’s bond markets reinforces the case for investing in China bonds. Particularly, China onshore bonds could be an attractive option to capture a long-term China opportunity due to its attractive yields, portfolio diversification benefits as well as superior total and volatility-adjusted returns.
The opening up of China’s financial and domestic markets will provide investors with further avenues for diversification and returns. It will also help in China’s pivot towards direct financing channels by providing discipline in pricing risk and efficient price discovery. As such, it contributes towards enhancing global influence and RMB internationalisation. Global index providers’ inclusion of China equity and bonds in their global indices will also support demand for the RMB. While risks certainly remain, the developmental potential for China’s bond market is huge with diverse product and alpha opportunities, and investors will need to understand and evaluate their options for gaining exposure to it.