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The Chinese bond market has taken a significant step towards integrating with the global financial system with the phased inclusion of Chinese government bonds and policy bank securities in the Bloomberg Barclays Global Aggregate Index starting this month.

The addition of these securities is being phased in over a 20-month period. When fully accounted for in the index, local currency Chinese bonds will be the fourth largest currency component following the US dollar, euro and Japanese yen. 

Bloomberg estimates that, using data as of January 31, 2018, the index will include eventually 386 Chinese securities and represent 5.49 per cent of a US$53.73 trillion index. The process will run over the next 20 months in 5% increments.

The inclusion of any emerging market carries many long-established conditions from the index-provider. A local currency debt market must be classified as investment grade and its currency must be freely tradable, convertible, hedgeable, and free of capital controls.  Bloomberg says that ongoing enhancements from the People’s Bank of China have resulted in RMB-denominated securities meeting these absolute index rules.

In addition to the Global Aggregate Index, Chinese RMB-denominated bonds will also be included in Bloomberg’s Global Treasury and EM Local Currency Government Indices.

It is expected that the FTSE indices and eventually J.P. Morgan will follow suit.

The move is part of increasing integration of China with the global financial system. Last year, Chinese A-shares were included in the MSCI Emerging Markets Index while the “connect” programme allows investors to buy certain shares and bonds through Hong Kong’s stock market.

The characteristics of the Chinese debt

In a report entitled Opening of China’s Bond Market: What Global Investors Need to Know, State Street Global Advisors hailed the move as historic. It also considered the characteristics of Chinese debt suggesting that the growth in Chinese borrowing over the past few years, which might worry investors, needs to be framed in the context of China’s ability to service and repay this debt.

China’s general government debt/ GDP ratio of less than 50% is at roughly half that of most large developed economies, and the bank says basically underpins China’s strong A+ sovereign credit rating while providing scope for future expansion if necessary.

However, SSGA notes that this healthy ratio does not tell the whole story.

Measuring the economy based on total debt, a different picture emerges, and the sharp rise in overall debt/ GDP from 164% in 2007 to 266% in 2017 gives some cause for concern.

However, SSGA balances this with three other factors. These are

  • China’s debt growth has been largely a re-allocation of internal capital and savings from consumption to longer-term investment.
  • China position as a net creditor to the world, with a positive net asset position of 14.7% of GDP
  • China’s large foreign exchange reserves which remain a significant support at approximately USD 3 trillion as of March 2018, though it notes that this is down from USD 4 trillion in 2014

SSGA also identifies that the yield on Chinese bonds — using a China Treasury and Policy Banks 1–10 Year Index — has rested about half way between the yields on developed market and EM sovereigns. It adds: “This should come as little surprise, given that China’s credit quality is more aligned with DM than EM sovereigns.”

Of course, Chinese bonds have not been entirely shunned by global investors. As HSBC points outs, international investors bought around US$81 billion of Chinese bonds last year, and this makes the country the largest recipient of foreign investment among emerging bond markets globally.

HSBC Global Research expects another US$150 billion to follow with the inclusion in the index. It also expects an additional allocation of shares an additional US$600 billion to head into Chinese stocks in the next five to ten years. What does the inclusion change?

Impact on the local market

Edmund Goh, Asian fixed income investment manager with Aberdeen Standard Investments, who is China-based says: “Adding China into Bloomberg and probably later FTSE will open the market up for international investors. Some would say they could invest without the index inclusion. But I think this inclusion changes two things. First how aggressively asset managers will pursue looking into this market and second demonstrating that the PBoC is willing to make market access easier. It makes a big difference.”

He suggests that it will bring significant chance to the onshore market long-term promising a much more diversified set of investors although he believes that for now most of the new investors coming into the Chinese market will be very conservative ones.

“They will aim for exposure to low or close to zero credit risk bonds – government and policy banks. In 12 to 18 months, you will see their presence. We are active in the market, and we can see the beginning of these flows now though it is still pretty small. I think increasingly you will see more active participation – it will increase the volume traded.”

“China needs a more diversified set of investors. The first step will be the interest rate market, the next step is to get foreign investors to be part of the credit markets though there is a language barrier and some idiosyncrasies with the local market. At the moment it won’t take off as the yield is not that attractive, but these things can change. These opportunities may come.”

He notes that default risk has risen recently though not in comparison to the US. Only recently have domestic investors started to embrace individual credit analysis and foreign investors can be an important influence. “Foreign asset managers are way, way ahead on the local fund houses.”

He also says he believes that global indexes are thinking putting in non-CGBs and security bank bonds in indices something that should also help with the development of the market.

Given Bloomberg’s decision to also offer products that exclude the Chinese bonds, Goh is sure that sure some international investors will look at a China excluded index. “The difference is that now it becomes an active decision – if you don’t want China you have to justify it. It becomes a non-mainstream product to exclude China, so with passive with an attractive yield and diversification benefit I would be surprised if most people go out of their way to exclude it out.”

He adds that this is a small step and the experiences of 2015 and 2016 with renminbi devaluation and huge stock market falls still play on Chinese policy makers’ minds given the loss of control for the government, the hurt felt by local investors and outflows of US$1 trillion.

“They want the local banks to become more stable and the long-term ambition has not changed. You need to make people feel safe when they invest. They want to make sure investors can take money out too.”

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