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In a world of fast-cooling growth and some overly hot asset markets, are Chinese government bonds the Goldilocks investment of 2021?
This might have seemed an odd thought in pre-coronavirus times. But as 2020 staggers to a close and central bankers everywhere slash rates toward zero, Beijing’s IOUs are offering yields punters cannot find in any other major economy.
Yields on China’s 10-year government bonds are a world-beating 3.22%.
That’s a far, far cry from the -0.63% and -0.33% rates investors are effectively paying Germany and France, respectively, for the honor of holding their debt. And the US pays only 0.77% on 10-year paper even as Washington’s debt burden skyrockets toward US$27 trillion – and highly likely well beyond that as the Covid-19 fallout worsens.
The reasons behind China’s higher rates are obvious enough. Its $16 trillion market is backed by a developing economy with limited liquidity and hedging tools, a giant and opaque state-sector and a rudimentary credit-rating system that can exacerbate risk and misallocate capital.
On Monday, though, President Xi Jinping’s government announced China grew an enviable 4.9% in the third quarter from a year ago.
The increase, powered both by strengthening manufacturing and consumer spending, suggests China may be experiencing something approaching the “V-shaped” recovery US President Donald Trump is struggling to generate.
Even better for Asia, imports surged 13.2% in September from a year ago. This suggests the region’s biggest economy is sharing its revival with neighbors.
Case in point: Japanese exports to China surged 14% in September from a year ago. Its shipments to the US rose a far less impressive 0.7%. Japan is still stumbling, as evidenced by the 17.2% drop in imports globally in September following a 20.8% decline in August. Exports to China, though, are a rare area of strength.
At the same time, China’s consumer price inflation dropped below 1.7% in September from a year earlier versus 2.4% in August.
All this means that as China leads the global economy out of the pandemic, inflation will remain tame as weak growth virtually everywhere restrains pricing power.
Bonding with Beijing
Not surprisingly, China is winning the attention of the globe’s most influential bond investors. That includes BlackRock, the very biggest with $7.81 trillion in assets.
In a series of recent interviews, BlackRock makes it clear mainland debt is hard to resist in today’s negligible-yield environment.
In a recent chat with CNBC, for example, Neeraj Seth, BlackRock’s head of Asian credit, said the colossus has a “positive” view of Beijing’s domestic bond market.
“We still see the China bond market to be fairly attractive,” Seth says. As he explains, “you have high nominal yield, potential to generate returns in an environment where rates are pretty low globally, and a portfolio diversification” that is only just getting started.
At the moment, foreigners account for less than 3% of all investment in Chinese onshore bonds. That is set to increase exponentially in the run-up to next year’s inclusion in a third global bond index – the latest one being the FTSE Russell benchmark.
The appeal of Chinese debt is deeper than that, of course. Along with offering myriad opportunities to build a diversified and resilient portfolio, there is far more scope for monetary easing in China without hurting bonds on an interest-rate differential basis.
“The People’s Bank of China has taken a more restrained approach to liquidity easing than the US Federal Reserve and the Chinese economy has recovered more quickly from the pandemic,” says analyst Shuncheng Zhang of Fitch Ratings.
The Goldilocks scenario, in other words, of a China that is neither too hot nor too cold stands firm.
The odds are, after all, that the Fed will be adding even more liquidity between now and the November 3 US election. Trump is almost certain to pressure Chairman Jerome Powell to add more liquidity to the stock market as his re-election chances wane.
October’s ‘China shock’
Irony abounds. Trump’s cronies are cooking up any number of “October surprise” shocks to win a second term. Yet the real jolt may come from China working in favor of opponent Joe Biden.
The shock in question is China displaying signs of the energetic recovery Trump’s team promised American voters. The third-quarter jump in Chinese GDP poses two significant problems for Trump.
One, China’s recovery from the coronavirus pandemic is leaving Trump’s economy in the dust. Though Covid-19 originated in Wuhan, China’s response continues to run circles around Washington’s.
The US has 8.2 million infections and counting, while China effectively contained Covid-19 and reopened its economy.
Two, it presents former Vice-President Biden with an enviable closing argument: the costs of Trump’s trade war are far exceeding the benefits his White House advertised.
“While some parts of the world may be suffering from an economic stutter, China’s economic momentum continues to build,” says strategist Kerry Craig of JP Morgan Asset Management.
The question now is whether China’s revival is for real.
The answer won’t present itself before November 3, but there’s reason to think China has a ways to go before declaring economic victory. Weak inflation trends around the globe work both ways, suggesting that China lacks sizable external engines to harness itself to in the months ahead.
European debt yields are below 1% – and below zero in some cases – for good reason. As Covid-19 second waves intensify, lockdowns will return in a hurry, slamming growth anew.
Ten-year yields in the UK, for example, are 0.18% with more than 744,000 coronavirus cases. A bigger increase with big economic implications will almost certainly drive yields lower.
Yet for all its relative attractiveness, China is still a buyer-beware market.
At the same moment BlackRock and its peers are eyeing Chinese bonds, the crisis of confidence among creditors of China Evergrande Group is a reminder of the mainland’s opacity and excesses. The globe’s most indebted developer owes them more than $120 billion, potentially posing system risks.
BlackRock’s Seth isn’t panicking, though, noting he “won’t be worried about” such dislocations because of the broad range of debt in which to invest. That includes government debt, municipal debt, state-owned enterprise and private corporations.
“When you look across that whole spectrum,” Seth says, “you can build a fairly diversified portfolio with pretty reasonable income and at the same time not really taking a lot of idiosyncratic risk.”
Yet, this is a moment for China to prove its market is ready for global prime time.
A long ‘To Do’ list
That means increasing transparency, loosening regulations, broadening hedging options, simplifying trading fees and strengthening the credit rating system.
In a recent report, the International Monetary Fund notes that “foreign investors don’t have sufficient derivative tools to hedge against exchange rate risk, interest rate risk and credit risk.”
Adds Calvin Ha of LGT Private Banking Asia: “While China has experienced rapid growth in the past decades and has become the world’s second-largest economy, the chance for it to be included as a major reserve currency remains limited, for now.
“The depth and liquidity of the Chinese government bond market remains limited when compared to those in other major economies, and reserve currencies tend to be held as government bonds rather than hard currency.”
Ha warns “these limitations, among other factors, makes it hard for the renminbi to obtain a reserve currency status in the near term. Having said that, some experts believe that should economic and financial structural reforms continue, the yuan could become a reserve currency in the near future given its significant share in the global economy.”
As China gets added to global indexes, it’s vital that financial reform keeps up with investment inflows.
Even so, signs abound that Chinese government debt is coming into its own.
Analyst Tim Cheung of Informa Global Markets points to estimates Beijing’s bonds will get a roughly 5.7% weighting in the FTSE Russell World Government Bond Index – adding a hefty $142 billion to the Chinese market.
“Once included,” Cheung says, “China will become the second highest-yielding country in the WGBI, which should be very appealing to yield-seekers.”
Heading toward 2021, the trend is China’s friend as it wins the battle for yield with the folks at BlackRock and elsewhere.
“The forces driving capital flows into China’s bond market” are not “likely to evaporate in the near term,” says analyst Wei He of Gavekal Research. “With the Federal Reserve committed to keeping policy rates at zero for an extended period, and Chinese policymakers reluctant to ease monetary policy significantly, Chinese bond yields will continue to look relatively attractive well into 2021 and likely beyond.”