China Throws Open Its Bond Market by Hayden Briscoe, Alliance Bernstein
China has reminded investors that there’s more to the country than worrisome economic indicators by announcing a significant step in the opening up of its domestic interbank bond market. The move has positive implications for capital flows and the strength of the currency.
One of the challenges in forming a clear understanding of China’s economy from the perspective of investment risk and reward is the complex interplay taking place between cyclical trends and structural reform.
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Slowing GDP growth, capital outflows, unsustainable credit growth, currency devaluations and volatile financial markets add up to an intimidating short- to-medium-term outlook.
Longer term, however, the prospects are brighter: the government’s commitment to reform—including the internationalization of the renminbi (RMB), liberalization of capital markets and encouragement of private capital (foreign and domestic) into currently state-owned enterprises—bodes well for sustainable future growth.
The coincidence of adverse economic conditions and the need to pursue reforms creates complications for China’s policymakers in pursuing their objectives, and in communicating them effectively to skeptical and skittish markets.
Depending on which way the news pendulum swings, there’s a tendency to blow hot and cold on China’s prospects when what’s needed is a more balanced perspective. With the latest announcement by the People’s Bank of China (PBC), the pendulum for the moment has definitely swung back to “hot.”
Come One, Come All
The PBC has expanded the pool of eligible foreign investors in the interbank market. They now include almost all foreign commercial banks, insurance companies, securities firms, asset management companies and long-term investors such as pension funds, charity funds and endowment funds.
Previously, access was limited to banks that provided RMB clearing and/or settlement, and only a few insurance companies gained entry, subject to eligibility criteria that were never clearly explained.
Securities firms and asset managers were limited to those participating in the Qualified Foreign Institutional Investor (QFII) and Renminbi Qualified Foreign Institutional Investor (RQFII) programs.
In other changes, the quota limit for long-term investors has been removed and the eligibility criteria for individual participants make no stipulation with regard to assets under management or years in operation.
The only criteria that institutions now have to satisfy are that they have been established in accordance with relevant local laws; they have sound management structures, internal control systems and standard business practices; their funds are legally sourced, and they are able to identify, understand, manage and bear the risk of owning bonds.
One of the reasons behind the timing of the move is likely to have been the domestic bond market’s strong growth—35% in 2015, with net issuance rising to RMB12.5 trillion (US$1.9 trillion). We expect growth to continue this year across the central and local government bond sectors, in negotiable certificates of deposit issued by banks and in corporate debt.
Apply a Balanced Perspective
The PBC’s initiative is a major development, in our view. It moves China’s bond market several steps closer to being included in global market indices—an event that will have a significant impact on investors in benchmarked fixed-income strategies, as they will have to restructure their portfolios to reflect the indices’ realignment.
We’ve estimated that this portfolio readjustment could result in inflows of US$2.5 trillion to China.
This offers an exciting prospect with huge implications for China’s economy, capital markets and currency; again, however, we need to take a balanced approach to assessing the risks and benefits.
While our conviction in China’s positive long-term prospects has gained further strength from the PBC’s move, the short-term outlook for China necessarily remains focused on the interplay between the government’s reform agenda, economic reality and market sentiment.
For example, a key policy consideration for the PBC at the moment is the injection of liquidity into the financial system to offset capital outflows and downward pressure on the currency triggered by investor anxiety. To what extent, if at all, will such action weigh on global bond index providers as they consider China’s inclusion in their benchmarks?
Such short-term questions persist; China, however, continues to make progress with its long-term policy objectives. Investors, in our view, need to consider both these points in forming a balanced view on China.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.
China’s Government Bonds