It’s usually with the benefit of hindsight that economists determine when major inflection points occurred. Sometimes, though, they’re glaringly obvious while unfolding. The inclusion of Chinese bonds in FTSE Russell’s benchmark index is such a moment.
FTSE Russell is a London-based provider of stock market indices and associated data services. Just one year after it rejected China’s US$16 trillion government debt market, FTSE Russell has done a u-turn.
As such, it is giving investors not only another way to bet on mainland bonds but a new reason to do so. China is the world’s second-biggest debt arena and yet foreigners account for less than 3% of dealing in the Chinese market.
FTSE Russell is the third key global benchmark to greenlight China’s government bonds. It might, however, be the most impactful. No offense to Bloomberg Barclays and JPMorgan Chase, but in finance timing is everything.
And this “good housekeeping” seal of approval for Beijing, coming amid the US-China trade and tech wars, generated just the headlines President Xi Jinping needed.
Sure, it’s grand that Goldman Sachs reckons this nod from FTSE Russell is good for about $140 billion of capital inflows in short order after the phase-in period starting on October 2021. They’re likely to be much bigger given how President Donald Trump is taking a wrecking ball to confidence in US Treasury securities.
The real impact, though, is how this news dovetails with the yuan’s growing strength in recent months – and Beijing’s own reform efforts.
Unleash the Trojan horses
Oftentimes, indexes are China’s best reformers.
The two years ahead of China’s June 2018 inclusion in the MSCI stock benchmark saw some of the most frantic liberalizations of the Xi era, that had begun in 2012. Ditto for the yuan’s 2016 entry into the International Monetary Fund’s top-five currency club.
Deepening foreign involvement exerts great pressure on China Inc to raise its game in ways Communist Party edicts can’t. This dynamic was precisely what Zhou Xiaochuan championed during his 15 years running the People’s Bank of China until 2018.
Former Governor Zhou was a protégé of Zhu Rongji, China’s reform-minded premier from 1998 to 2003. As China’s No 2 official, Zhu oversaw the nation’s entry into the World Trade Organization and harnessed that accession to pull off one of China’s most assertive shakeups of state-owned enterprises.
It was bloody: Zhu eliminated 40 million-plus jobs and shuttered 60,000 companies.
Mentee Zhou introduced a similar “Trojan horse” to the PBOC. Once the rules and norms of an entity like the IMF or an indexer like the MCSI are inside China’s walls, the theory goes, there is nothing to do but open and internationalize the system.
Entering the IMF’s special drawing rights basket, for example, meant adhering to levels of transparency – including the foreign-exchange reserve holdings Beijing had treated as a state secret – and throttling back on currency manipulation and capital controls.
It was the first time the IMF had added a new currency since the euro in 1999 – an obvious signal that the yuan’s moment had arrived.
Zhou’s PBOC called it “a milestone in the internationalization of the renminbi and is an affirmation of the success of China’s economic development and results of the reform and opening up of the financial sector.”
It also was a landmark moment for reformers, who knew how hard it would be for Beijing to put the proverbial genie back into the bottle.
China’s moves to open its financial system meant index investors who, in the past, might have avoided the mainland “now have to take a view on China,” says Jonathan Orr, a portfolio manager at Goldman Sachs Asset Management.
The gates creak open
This FTSE Russell milestone is already generating its own flurry of reformist energy. Beijing just announced fresh steps to broaden the range of investment options available to foreigners.
The steps, effective November 1, involve programs with wonky names like “Qualified Foreign Institutional Investors” and “RMB Qualified Foreign Institutional Investors.”
It’s no coincidence that they were unveiled the same day FTSE Russell embraced Chinese sovereign debt to its gauges. And they are vital moves to enable global punters to play a bigger role in China’s swelling debt arena and $9.4 trillion equities market.
Changes include: growing the derivatives market by letting overseas punters use financial and commodity futures and options; allowing foreigners to pledge notes they hold as collateral for cash; opening the National Equities Exchange and Quotations, or NEEQ, stock system in Beijing; allowing foreigners to do margin trading and increasing access to investment funds.
The bottom line is “increasing numbers of international asset managers will seek to establish full onshore operations in China,” says analyst Li Huang of Fitch Ratings.
These upgrades will, over time, increase the efficiency of, and trust in, Chinese capital markets. They will, as Thomas Fang of UBS puts it, “fundamentally relieve major bottlenecks for foreign institutional investors seeking to invest in China.”
They also dovetail with Xi’s ambitious designs on the yuan playing a larger role in global trade and finance. “It’s a sign,” says Patrick Shum, director of investments at Tengard Holdings, that “China’s markets are becoming more and more open.”
Big yields, strong yen
It certainly helps that yields on 10-year Chinese sovereign bonds are more than 3.11%, an attractive rate relative to 0.69% in the US and 0.01% in Japan. China’s is “a very high number in the global context,” says strategist Ben Powell of BlackRock Investment Institute.
This, adds economist Larry Hu of Macquarie Capital, “will help facilitate more inflows in the wake of a weak dollar.”
The yuan just had its best quarter versus the dollar since 2008, gaining 3.7%. That dynamic speaks to the appeal of mainland assets at a moment when China is recovering faster than other major economies, growing perhaps as much as 2% this year.
As analysts at JP Morgan Chase put it in a note to clients: “FX investors have accepted the notion of Chinese exceptionalism in growth.”
JP Morgan reckons that this exceptionalism, coupled with the FTSE Russell news, will be good for about $10 billion of inflows into Chinese government debt each month. One channel worth watching: Japanese investors are big users of the index.
And if any class of buyers is desperate for yield, it’s the Japanese.
The yuan’s rise also is a sign of Xi’s tolerance for a stronger exchange rate. As Covid-19 slams growth everywhere, China could use the stimulus afforded by a strong yuan versus the dollar.
The rise is surely justified given China’s relative stability. While it opened 2020 with the slowest growth in 30 years, it may be the only top-ten economy to enter 2021 comfortably in the black.
That’s a world away from the 6.8% contraction it saw in the January-March quarter. The divergence is particularly sharp when compared to a US financial system sinking under the weight of seven million-plus Covid-19 infections.
And even with a rising yuan, China is seeing solid increases in exports, industrial production and retail sales. Critically, this revival is unfolding without the aggressive monetary easing seen in Washington and Tokyo.
The PBOC, of course, could be flooding markets with liquidity to weaken the yuan. But both Xi and the PBOC are taking a surprisingly hands-off approach to currency trends. That augurs well for China’s longer-term reform prospects. So does the steady opening to foreign investors.
Control instinct vs market forces
There’s a sizable risk to consider, though. China could pay a price if reforms don’t keep pace with rapidly increased international involvement in its economy and the openness and accountability that will require.
One group with which Xi’s men will have to contend: so-called “bond vigilantes.”
This breed of Wall Street player is famed for taking matters into their own hands to protest against governments, monetary or corporate policies they deem unproductive or dangerous. They express their dissatisfaction by driving up bond yields, raising governments’ or companies’ borrowing costs in the process.
This dynamic may force Xi to give up some control. One of the great paradoxes of Xi’s efforts to liberalize the financial system is basic transparency going the other way. If you told investors in 1998, when Premier Zhu and his boss President Jiang Zemin held the reins, that censorship would be even stricter 22 years on, few would’ve believed it.
Back around that time, Jiang even held a live joint press conference in Beijing with then-US president Bill Clinton, an event carried on local television, too. At the time, journalists and pundits were supremely certain that China would be internalizing Hong Kong’s democracy. But on Xi’s watch since 2012, China has become even more of a black box.
This opacity is a risk all its own. There are valid worries about China experiencing a “Minsky moment” – when a debt-and-credit-fueled boom meets a nasty end. Every industrializing nation suffers from this risk. And more often than not, such episodes come out of nowhere.
It happened in Japan in 1990, Mexico in 1994, Southeast Asia in 1997, Russia in 1998, Lehman Brothers in 2008 and the “taper tantrum” in emerging markets in 2013. Can Beijing beat the fate that befalls all industrializing economies?
Surely, China is run by some very smart and talented officials.
Yet the murkiness of Xi’s financial system is a risk all its own. One problem is that local and foreign media have little latitude to report on – and police – the financial state of play in China.
Xi’s government, meantime, favors control over the flow of independent information. That can warp the pricing mechanism role that markets play. That means credit spreads, yield levels and secondary-trading dynamics that investors need to set bid and ask levels can be out of whack. Analysts at global credit rating companies, for instance, struggle to comprehend mainland balance sheets.
The dearth of an established and trusted credit-rating system for local currency bonds needs addressing. That is the problem, says IMF economist Raphael Lam.
Local credit ratings too rarely, in Lam’s view, “differentiate sufficiently among provinces,” all too many of which receive ratings too close to AAA for comfort. As foreign capital pours into China, Xi’s government will be under pressure to give Fitch, Moody’s and S&P Global Ratings greater scope to rate municipal and corporate debt along with sovereign issues.
Increased foreign involvement can help fill in many of these blanks. As the bond vigilantes make their way around China Inc, they will highlight and call out deficiencies in everything from transparency to securities settlement to the ability to discern the identity of counterparties to regulatory shifts that run afoul of Xi’s pledge to let market forces play a “decisive” role.
If foreign punters don’t like what they encounter, they will simply leave China and take their capital with them. They also will unload their criticism via television hits on Bloomberg, CNBC, Fox Business and elsewhere.
As these Trojan horses gallop into China’s financial system, Beijing has little choice but to accelerate efforts to modernize its economy. The more global involvement in China, the merrier its reformers will be.