The case for China bonds comes down to fundamentals

As was highlighted in last month's paper the case for allocating funds to Chinese fixed income markets based on low historical correlations to other global bond markets is flawed as correlations are likely to rise over time. Ironically it is exactly the fundamentals which are likely to be driving this increase in correlations which provides the strongest case for investing in Chinese fixed income as part of a broader global bond portfolio.

The overarching fundamental dynamic supporting China’s bond market over the longer term is the political desire of the central government to have more control over the economy. An impediment to achieving this is the position of the USD as the world’s reserve currency. With the USD as the world’s reserve currency a large proportion of transactions involving the commodities which China needs to import are denominated in USDs. In turn this requires the Bank of China to maintain large holdings of USDs, i.e. investments in US treasuries. The ability of the Bank of China to reduce such USD holdings is limited as one of the rationales for central banks holding foreign reserves is as a precautionary measure to absorb or self-insure against balance of payments shocks including sudden stops in international flows. Having to invest such large amounts into a foreign country’s bond market is not seen as optimal by the central government of China. The key to reducing the need to hold large foreign exchange reserve balances in US treasuries is to reduce China’s reliance on the U.S. dollar as a medium for international trade. This in turn requires that more global transactions be denominated in yuan as opposed to USD.

The cornerstone to reducing China’s reliance on USD as a medium of international trade is having the yuan accepted as a reserve currency. On November 30, 2015 the International Monetary Fund awarded the yuan status as a reserve currency. This was followed by the yuan being added to its Special Drawing Rights (‘SDR’) basket on October 1, 2016. With its inclusion in the SDR basket the yuan joined an exclusive club which includes the euro, Japanese yen, British pound and U.S. dollar. Its inclusion as a reserve currency and as part of the SDR basket, though in part simply reflecting the growing importance of the yuan as a traded currency, is also part of a longer term political objective. Ultimately rather than being an end in itself this is only an initial step in the Chinese central government’s longer term objective of having the yuan eventually replace the USD as the world’s reserve currency. Yet before this can be achieved the yuan must prove a success as a reserve currency.

The success of the yuan as a reserve currency is an important step and it is here that China still has some way to go. To gauge the scale of the task it is worth considering that and the end of 2018 the global currency reserves of central banks comprised 69% USD, 20% Euro and only around 2% yuan. To further highlight the task ahead Chart 1 shows the currency reserve composition of the ECB.

Though it’s inclusion in the SDR basket has prompted central banks’ to start holding reserves in yuan the amount is still quite small and dwarfed by USD holdings. This illustrates that simply comprising a large part of international trade and having one of the world’s largest bond markets is not enough for the yuan to prove a success as a reserve currency.

Part of this lack of demand from central banks for yuan holdings as reserves may be down to lack of certainty regarding the future path of policies by the central government; i.e. Chinese financial markets are still evolving. This highlights that in order to achieve its longer term goals the central government will need to continue down the path of liberalisation and reform of domestic financial markets thereby :

• Allowing free trade in the yuan and facilitating currency hedging; and
• Increasing :
• transparency of China’s financial markets.
• transparency and stability of Chinese monetary policies.
• the size and liquidity of China’s central government bond market.

Successfully achieving these objectives will increase the attraction of the yuan as a reserve currency for central banks. By increasing their holdings central banks will assist in bringing about a convergence in the yield differential between Chinese government bonds and US treasuries. Achieving success of the yuan as a reserve currency will therefore, not only facilitate the central government being able to reduce its reliance on the USD, also structurally lower interest rates as yield convergence occurs.

Ongoing reform of the domestic financial markets will also increase investor demand for Chinese bonds further assisting yield convergence. To date a lot of the offshore demand for Chinese bonds has been from central banks wanting to diversify their reserves into yuan assets – namely government bonds. However equally important is inclusion of Chinese bonds in broader global bond indices. Index inclusion will spur a wider range of investors into China as investment managers from around the world will adjust their portfolios to track changes in the indices they use to benchmark their performance. This process of broader inclusion began with the announcement of inclusion of Chinese bonds in the Bloomberg Barclays Global Aggregate Index from 1^st April 2019. Importantly one of the key criteria for inclusion of bonds within an index is liquidity; i.e. only those bonds which are viewed as being actively tradable to qualify for inclusion in the bond indices. This means that not just size of bond markets but also ongoing liberalisation of those markets is essential for the weighting to China bonds to increase within indices over time.

The Chinese central government is pursuing a longer term objective of making the yuan one of the major, if not the major, reserve currencies. Achieving such an objective will require the ongoing reform of the domestic financial system. Yet if successful the rewards will be material in not only increasing economic independence but also lowering the premium currently attached to Chinese government bonds over US treasuries. Though the length of time this takes is uncertain the determination of the Chinese government to achieve this objective should not be underestimated. It is this policy objective and the associated fundamental forces that will drive yield convergence which is one of the central reasons for holding material exposures to Chinese government bonds over the longer term.