China and the Expanding Global Bond Landscape

Transcription

1 Lazard Perspectives China and the Expanding Global Bond Landscape For years, the Chinese bond market, currently the world s third-largest, was effectively closed to offshore investors. This has begun to change recently as China has accelerated the pace of liberalization of its vast bond market. We expect this process to continue and the implications are significant for China s financial system and fixed income investors alike. The evolution of the Chinese bond market is a result of concerted efforts by Chinese authorities to increase capital flows and further establish the global relevance of the renminbi. For emerging markets debt investors, access to Chinese bonds greatly expands the investment universe with the addition of a new safe haven asset. Lazard s Emerging Markets Debt team believes it is critical for investors to understand and prepare for the significant changes taking place in China s fixed income market.

2 2 China s Bond Market Has Evolved Rapidly China has the second-largest economy in the world, accounting for 15% of global GDP. The $4 trillion Chinese government bond (CGB) market has developed rapidly and may soon surpass Japan to become the second-largest bond market in the world (Exhibit 1). In addition, the Chinese renminbi has been designated a reserve currency by the International Monetary Fund (IMF). Yet Chinese bonds, which until recently have been difficult for foreign investors to access, have largely been ignored by the widely followed fixed income indices. We expect this to change in the coming months and the implications are important for both Chinese capital markets and investors. Over the past several years, China has taken serious steps to liberalize its capital markets (Exhibit 2). The pace of reform has accelerated recently as the government recognizes that an easing of capital restrictions is necessary to support its economic transition and reform agenda. With respect to the Chinese bond market, several key developments have taken place, which have helped pave the way for increased foreign investor participation. First, in early 216, the People s Bank of China (PBoC) took a major step in improving accessibility by removing quota limits on foreign ownership of CGBs and streamlining the application process and operational procedures for trading in the China interbank bond market (CIBM). This was followed by the official launch of the Bond Connect trading platform in July 217. Bond Connect is a major breakthrough, in our view, as it allows offshore investors to access the domestic China bond market via Hong Kong for the first time. The platform is designed to be more efficient and convenient from an operational standpoint, as foreign investors no longer have to complete the rigorous and time-consuming For more information on Bond Connect, please read: Opening Up: A Primer on China s Bond Connect Platform Exhibit 1 China Could Overtake Japan s Bond Market ($T, Debt Outstanding) (%) United States Japan China United Kingdom Financial Corporation [LHS] France Non-Financial Corporation [LHS] Source: Bank for International Settlements process that was previously needed to register on the mainland. Moreover, Bond Connect has far fewer restrictions than other avenues have for offshore investors, including no restrictions on holding periods, repatriation, and quotas. The next key step in this process will be the inclusion of CGBs in the most widely followed emerging markets and global fixed income indices. We view this as a question of when and not if. Bloomberg partly settled this with its March 218 announcement that CGBs will be added to its flagship Bloomberg-Barclays Global Aggregate Index beginning in April 219, provided that several planned operational enhancements are implemented by the PBoC and Ministry of Finance. China will be phased in gradually over a 2-month period and is expected to constitute 5.5% of the index after full inclusion. We believe other index providers are likely to follow suit shortly. China has yet to be added to the most widely followed local currency emerging markets debt indices, but we expect this to change in the near term. China was placed on index watch for potential inclusion in the J.P. Morgan GBI-EM Global Diversified Index in March 216. In its latest review, J.P. Morgan lauded the launch of Bond Connect as a positive step, but noted that the platform needs to establish a track record sufficient for dedicated managers to replicate Germany Italy Canada Netherlands Spain General Government [LHS] Government Debt-to-GDP [RHS]

3 3 Exhibit 2 The Pace of Developments in China s Capital Market Liberalization Process Has Accelerated Date Event Nov 214 Jul 215 Aug 215 Sep 215 Nov 215 Shanghai Hong Kong Stock Connect goes live allowing offshore investors to trade onshore shares in Hong Kong PBoC issues rules to make it easier for foreign central banks/sovereign wealth funds to access CIBM (including bond futures and IRS) no quota required PBoC devalues the renminbi by 2% and announces a new, more market-based foreign-exchange (FX) regime. Daily fixing will be based on: (1) previous day s spot closing; (2) supply and demand; (3) overnight moves in other currencies PBoC releases details on how foreign central banks and similar institutions can conduct FX trading in China s interbank market First batch of foreign central banks and similar institutions register to enter China s interbank FX market Dec 215 IMF announces renminbi will be included in the special drawing right (SDR) basket with a weighting of 1.9% Feb 216 Mar 216 May 216 Jan 217 Feb 217 Mar 217 Qualified Foreign Institutional Investor (QFII) withdrawal fund lock-up period is reduced from one year to three months. PBoC announces opening up of CIBM to foreign institutional investors without details J.P. Morgan publishes initial assessment of China s eligibility for the GBI-EM Global indices stating that 3-month minimum holding period and monthly withdrawal limits constitute capital controls Citi announces it will review China s eligibility in the Citi World Government Bond Index based on: (1) minimum market size; (2) credit quality; (3) lack of barriers to entry. First two criteria are already met J.P. Morgan places China on index watch for inclusion in the J.P. Morgan GBI-EM Global family of indices China Securities Regulatory Commission clarifies beneficial ownership under QFII/renminbi QFII, addressing one of the three key concerns that MSCI had for not including A-shares in its index PBoC and State Administration of Foreign Exchange (SAFE) jointly publish detailed regulation on foreign currency management in the interbank market and on foreign CIBM access Bloomberg-Barclays announces new emerging and global fixed income indices that will include China to be launched in March 217 while maintaining flagship indices that exclude CGBs China opens its currency derivative market, allowing foreign investors to use more liquid onshore FX derivative products to hedge currency risks Hong Kong China Bond Connect platform is officially announced, which will enable offshore investors to trade in the CIBM market from Hong Kong accounts for the first time Hong Kong Exchanges and Clearing announces 5-year China Treasury Bond Futures contract, the offshore market s first futures contract on CGBs Bloomberg-Barclays launches the Global Aggregate + China, and EM Local Currency + China indices. China comprises 5.3% and 39.2% of the indices, respectively Jun 217 MSCI announces China A-share inclusion in two steps: May 218 and August 218 Jul 217 Feb 218 Trading begins on Bond Connect. Over $1 billon of transactions were conducted on the first day, according to Chinese authorities Citi adds China to its emerging markets and regional government bond indices following its March 217 announcement Mar 218 Ongoing Bloomberg-Barclays announces that CGBs will be added to its flagship Global Aggregate Index beginning in April 219 with an estimated weight of 5.5% upon full inclusion in October 22 J.P. Morgan continues to conduct index governance review for the addition of China to its flagship GBI-EM Global family of indices Source: Lazard, Barclays, J.P. Morgan, PBoC, Reuters, UBS potential index exposure. 1 J.P. Morgan will reassess China s eligibility in 218 and we believe an announcement on official inclusion could come before year-end. Foreign Inflows Are Set to Rise Chinese authorities have a vested interest in continuing to open China s bond market to foreign investors. First, further capital market liberalization should help attract portfolio flows, easing capital outflow pressures and helping China s capital account. This will also encourage the continued internationalization of the renminbi, helping cement its global relevance. Evidence suggests that the results from the liberalization efforts thus far have been highly encouraging on this front. The share of government bonds owned by foreign investors has doubled since the end of 215. Yet the degree of foreign ownership remains low at roughly 5%, well below levels of regional peers, such as Indonesia and Malaysia where foreign investors own 3% 4% of outstanding government bonds. As restrictions are eased and fixed income benchmark providers inevitably include China, this figure should continue to rise. We estimate that inclusion in the bellwether global and emerging markets fixed income indices could lead to inflows of about $35 billion (Exhibit 3), representing about 8% of the current face amount of outstanding CGBs. However, initial inflows are likely to be much lower as China will be phased into indices over an extended period of time and some investors may elect to switch to ex-china indices. Nonetheless, the momentum

4 4 Exhibit 3 Potential Flows into China from Index Inclusion Could Be Significant Index Bloomberg-Barclays Global Aggregate Citi World Government Bond Index Citi World Broad IG Bond Index J.P. Morgan GBI-EM Global Diversified Estimated AUM Benchmarked to Index ($B) Estimated China Index Weight (%) Estimated Flows ($B) 2, , , Total 35. Forecasted or estimated results do not represent a promise or guarantee of future results and are subject to change. Source: Lazard, Bloomberg, Citi, J.P. Morgan, Morgan Stanley China has historically outperformed the broad local currency index during periods of heightened risk aversion towards emerging markets and has lagged during market rallies, as evidenced by performance over the latest cycle (Exhibit 4). During the Emerging Markets Debt Bear Market which we define as the period beginning with the taper tantrum in April 213 and ending with the bottoming of commodity prices in January 216, China significantly outperformed the broad local currency emerging markets debt asset class. However, much of this outperformance has been reversed in the period since as emerging markets fundamentals, the global macro backdrop, and investor sentiment towards the asset class have significantly improved. Nevertheless, China significantly outperformed over the full period on both an absolute and risk-adjusted basis. In addition, China s attractive carry relative to the US, European, and Japanese government bond markets helped China outperform developed markets during a period characterized by negative sentiment towards the country (Exhibit 5). is clear and the Chinese bond market is becoming increasingly difficult for benchmark providers to ignore. Importantly, China s integration in the global bond market will bring several benefits to China s financial markets beyond attracting portfolio flows and further establishing the relevance of the renminbi. For example, by diversifying sources of capital China can reduce systemic risk in the banking sector. An increase in investor demand should allow for the issuance of longer-dated bonds, helping China develop its local yield curve. In turn, this can allow for better pricing of risk for the local corporate bond market (i.e., price discovery) which will help facilitate a shift from onshore bank financing to capital market financing. The PBoC has expressed a strong desire for more Chinese companies to obtain financing in local corporate bond markets in order to reduce systemic risk in the banking system. Additionally, over time we would expect to see an increase in foreign entities issuing bonds onshore that are denominated in renminbi. A New Opportunity, but Not Without Risks China s vast bond market greatly expands the investment universe and represents a new opportunity for emerging markets fixed income investors. While the characteristics of Chinese bonds are likely to evolve as the market becomes more integrated with global capital markets, CGBs have historically exhibited unique characteristics that may enhance the overall risk-adjusted return profile of local currency emerging markets debt portfolios. Chinese bonds have the potential to be a source of both higher returns and diversification. Exhibit 4 China Has Historically Outperformed Emerging Markets on an Absolute and Risk-Adjusted Basis EMD Bear Market Performance (%) EMD Bull Market Performance (%) Full Period Performance (%) Full Period Sharpe Ratio China Local Currency EMD Excess Return N/A EMD Bear Market = 31 March 213 to 31 January 216; EMD Bull Market = 31 January 216 to 28 February 218; Local Currency EMD = JPM GBI-EM Global Diversified. Returns over periods greater than one year are annualized. Source: Lazard, J.P. Morgan Exhibit 5 CGBs Offer Attractive Carry Relative to Developed Markets Five-Year Local Government Bond Yields (%) United States Euro zone 211 Source: Bloomberg 212 Japan China

5 5 Exhibit 6 CGBs Yields Tend To Behave Like a Flight to Quality Asset Exhibit 7 China s Correlation to Emerging Markets Has Risen, but Remains Low to US Treasuries Correlation Source: Lazard, Bloomberg United States 21 Emerging Markets Indices used: China = JPM GBI-EM Broad China Index; EM = JPM GBI-EM Global Diversified Index; US = JPM GBI US Index Source: Lazard, Bloomberg VIX Index [LHS] year China Government Bond [RHS] Yield (%) 218 The safe haven characteristics are also evidenced by the behavior of CGB yields during periods of market turmoil. In periods when volatility spikes, CGB yields have typically rallied (Exhibit 6). This contrasts with the typical behavior of local rates in emerging markets. While local rates tend to be correlated with core markets under normal market conditions, local rates tend to perform more like risk assets during periods of severe market stress. Consistent with these characteristics, China may also serve as a source of diversification for local currency emerging markets debt investors. Historically, local currency debt has exhibited a volatility of roughly 1% 12%, owing to the more volatile nature of currencies relative to fixed income. We estimate that had China historically been included in the index, realized volatility would have been 9% 11%, representing a roughly 1% decrease, owing to China s lower volatility and relatively low correlation with the broader index (Exhibit 7). However, the potential diversification benefit is likely to be less significant going forward. China s lower historical volatility and correlations can be attributed to the pegged Exhibit 8 China Is Projected to Have the Maximum Index Weight of 1% Date YTM (%) Current Weight (%) Projected Weight(%) Difference (%) China South Africa Poland Mexico Indonesia Brazil Philippines Uruguay Argentina Chile Peru Czech Republic Romania Hungary Malaysia Colombia Russia Thailand Turkey Forecasted or estimated results do not represent a promise or guarantee of future results and are subject to change. Totals may not sum to 1% due to rounding. Source: Lazard, J.P. Morgan currency regime prior to August 215, as well as a lack of integration with global financial markets. While the renminbi is now managed under a managed float regime, it is likely to move towards a true floating regime over time and the bond market may continue to become more integrated with global assets as capital controls are eased. Moreover, we note that other safe havens such as Thailand have actually exhibited higher correlations to US Treasuries. These risk and return characteristics are not surprising given China s higher credit quality relative to other emerging markets, the government s (still strong) control over the domestic economy, and relatively low level of foreign bond ownership. Thus, the safe haven characteristics and diversification benefits of CGBs are likely to be diluted somewhat going forward. However, the extent and timing of this remains to be seen. When China is added to the J.P. Morgan GBI-EM Global indices, it will be phased in gradually in order to allow investors ample time to adjust, similar to the approach that will be used by Bloomberg- Barclays for the Global Aggregate Index. CGBs will be added to J.P. Morgan s Global Diversified version of the index in 1% increments over a period of 1 months at which time China will reach the full index weight of 1%. Interestingly, as a result of a somewhat esoteric capping methodology that J.P. Morgan applies in constructing the

6 6 diversified version of the index, the weights of larger constituents, such as South Africa, Poland, and Mexico, are actually projected to rise slightly (Exhibit 8). Meanwhile, it is the "medium-sized" constituent countries that will see the largest absolute declines in their index weights. The top-level characteristics of the index are not projected to change meaningfully with the overall yield expected to decline by about 15 basis points (bps), the duration largely unchanged, and the average quality increasing from BBB to BBB+, based on current characteristics. Importantly, the opportunities arising in CGBs are not without risks. Among the key risks we are focused on are the lack of transparency and potential for a policy error, as well as tail risks associated with the currency and potential bursting of a credit bubble. China s bond and currency markets are both largely policy driven, economic policy is not transparent, and policy makers do not communicate effectively with the market in the same manner as governments in other key risk centers. Moreover, economic data remains opaque and is widely questioned by market participants. While the government s control over the economy has typically been a source of stability, the risk of a policy error may have increasingly severe consequences. China s debt levels have risen significantly in recent years as credit has been the main source of growth. While government debt levels appear manageable, non-government debt levels are more concerning due to the highly leveraged shadow banking sector. We believe a full-blown credit crisis is unlikely in the near term, but China will ultimately need to de-lever. While the impact of such a tail event would be most pronounced for investors in the non-government sector, we cannot discount the risk of China imposing capital controls on government bond investors. We also view currency risk as more of a tail risk. For example, the government could abandon the managed peg regime and devalue the renminbi in retaliation for anti-china trade protectionism by the US administration. Too Big To Ignore The pace of liberalization of China s vast bond market has increased considerably in recent years. This is likely to continue and the implications are significant for both the Chinese financial system and fixed income investors. Open capital markets are a double-edged sword. Higher foreign participation brings with it vulnerability to global risk sentiment and investment flows. However, Chinese authorities recognize that an easing of capital restrictions is necessary to support its economic transition and reform agenda as it would create benefits such as a reduction in systemic risk of the banking sector. Clearly, the momentum is in the direction of greater liberalization and this is unlikely to reverse course. Although China has the third-largest bond market in the world, it has yet to be included in any major bond index because of limited market access, capital controls, and operational issues for foreign investors. The recent announcement that China will be included in the Bloomberg-Barclays Global Aggregate Index, which is tracked by an estimated $2.5 trillion in assets, highlights that China s inclusion in other global and emerging markets bond indices is inevitable. This will result in a vastly expanded investment universe, and for emerging markets debt investors, in particular, a new safe haven asset. In our view, it is imperative that investors understand and prepare for the significant changes under way.

7 7 About The Team The Lazard Emerging Markets Debt team focuses on understanding the entire opportunity set in our investment universe. We combine our expertise with the benefits of Lazard s emerging markets platform. We seek to deliver comprehensive insight to our investors, through research into currency movements, the stability of equity and debt structure, and the broad business environment. This content represents the views of the author(s), and its conclusions may vary from those held elsewhere within Lazard Asset Management. Lazard is committed to giving our investment professionals the autonomy to develop their own investment views, which are informed by a robust exchange of ideas throughout the firm. Notes 1 As of 8 September 217. Source: J.P. Morgan Index Governance Review Important Information Published on 1 May 218. An investment in bonds carries risk. If interest rates rise, bond prices usually decline. The longer a bond s maturity, the greater the impact a change in interest rates can have on its price. If you do not hold a bond until maturity, you may experience a gain or loss when you sell. Bonds also carry the risk of default, which is the risk that the issuer is unable to make further income and principal payments. Other risks, including inflation risk, call risk, and pre-payment risk, also apply. High yield securities (also referred to as junk bonds ) inherently have a higher degree of market risk, default risk, and credit risk. Securities in certain non-domestic countries may be less liquid, more volatile, and less subject to governmental supervision than in one s home market. The values of these securities may be affected by changes in currency rates, application of a country s specific tax laws, changes in government administration, and economic and monetary policy. Emerging markets securities carry special risks, such as less developed or less efficient trading markets, a lack of company information, and differing auditing and legal standards. The securities markets of emerging markets countries can be extremely volatile; performance can also be influenced by political, social, and economic factors affecting companies in these countries. Derivatives transactions, including those entered into for hedging purposes, may reduce returns or increase volatility, perhaps substantially. Forward currency contracts, and other derivatives investments are subject to the risk of default by the counterparty, can be illiquid and are subject to many of the risks of, and can be highly sensitive to changes in the value of, the related currency or other reference asset. As such, a small investment could have a potentially large impact on performance. 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