China’s data has just made the case for faster reforms to its domestic bond market, already the world’s third biggest, but lagging behind its peers in foreign ownership and liquidity.
Growth in the world’s second largest economy has slid to near 30-year lows in the third quarter and recent data shows that the worst is yet to come. This month fixed asset investment hit the lowest on record, retail sales growth hovered around a 16-year trough and industrial output was still slowing.
Beijing has moved quickly – it reduced its lending benchmark rate to help lower borrowers’ funding costs this week and the move was preceded by a reduction in the reverse repo rate which would inject US$26 billion into the banking system. In early November, it cut the interest rate on its medium-term lending facility.
Clearly authorities are worried about the economic deceleration.
There has been a clear signal in recent years they prefer fiscal policy as the tool for protecting the economy rather than monetary policy. While there have been tax and fee cuts and reductions made to social security contributions in the past 18 months, they don’t give the immediate bang for the buck the way infrastructure investment spending does. That could be an option.
“A rapid increase in local government issuance since Q1 has meant the quota for 2019 has run out already. There is consensus they will front load in Q4 and the overall special projects quota for 2020 will be widened to between 2.5 and 3 trillion yuan,” said Aidan Yao, senior economist at AXA Investment Managers.
This is particularly essential as infrastructure is expected to outperform both property and manufacturing in 2020.
The timing could not be more appropriate to make overseas access easier for the country’s $13.7 trillion bond market, which has recently risen to more than 2%, according to a Moody’s report. But that pales in comparison with the developed markets like Japan (12.1%) and the US (28%), as well as the emerging markets like Indonesia (39%) and Malaysia (24%).
“As the local government bond universe expands, it makes sense for Beijing to look at increased foreign participation and for foreign investors to look at China fixed income as an integral part of their portfolio,” Yao said.
As China enters global benchmarks, it is getting harder for international investors to ignore the world’s second largest capital market.
Doing so in the past posed no systemic risks as yuan assets were not part of the global indices. But not investing in China now and going forward, as it commands a growing share of the global benchmark, will present increasing track error risks to international investors.
Avoiding such a strategic risk – by making an off-benchmark bet – should continue to encourage foreign inflows to the onshore markets.
Sure, there are issues that China needs to fix at its end – removing the uncertainty on the tax laws, streamlining access and deepening the derivatives market to make the index inclusion more impactful. But the road ahead is largely clear.
It may be time to stop trading China fixed income like a bomb waiting to explode. In the past one could harbor these prejudices and get away with it since it was not in the index. But now by ignoring China bonds, investors might be making a strategic decision to underweigh China.