TOKYO – Depending on how one looks at it, 2021 is either the very best or absolute worst moment for China’s bond market to go global.
The bullish camp points to the US dollar’s troubles and a US Treasury Department gearing up for an unprecedented borrowing binge as US debt tops US$28 trillion. That makes this an ideal window for British index giant FTSE Russell to add Chinese government bonds to its benchmark World Government Bond Index.
The bear camp worries that Beijing’s opacity and control-freak tendencies will collide with an investor class apt to punish wayward governments with higher borrowing costs. And what Chinese President Xi Jinping must court is the ranks of the undecided – exemplified by Japan’s Government Pension Investment Fund (GPIF).
Winning the trust of one of the globe’s biggest investment pools, with $1.6 trillion worth of assets, is easier said than done. But if Xi’s financial team can win over Finance Minister Taro Aso’s crew, it should convince anyone China is, indeed, ready for the global debt market prime time.
GPIF doesn’t have to adhere strictly to FTSE Russell weightings when mainland debt gets added to the index in October. Though it’s long favored a passive management model, betting big on Chinese government debt makes for quite a dilemma for GPIF president Masataka Miyazono and his staff.
The benefits are clear enough. At a moment when 10-year Japanese debt yields a negligible 0.09% and comparable US bonds yield a paltry 1.65%, China’s $18 trillion market is in the global spotlight with a 3.22% rate that is hard for punters to resist.
But so far, GPIF has done exactly that.
As of the end of March, the fund had zero exposure to yuan-denominated bonds. Avoiding attractive Chinese returns means Japan’s main investment vehicle risks underperforming the broader market.
Roughly $2.5 trillion of managed assets are tied to the FTSE Russell’s bond benchmark. For now, the plan is for Chinese public debt to assume a 5.25% weighting, meaning about $130 billion of debt that would have to be purchased. That’s sure to have investors loading up on Chinese debt and hoping for a price bump this year.
“In March, inflows reversed, thanks to higher US yields and a weakening renminbi,” says analyst Wei He at Gavekal Dragonomics. “But in the longer term, renminbi bonds are still attractive both on fundamentals and due to the inclusion of Chinese government bonds in the FTSE-Russell” six months out.
Analyst Becky Liu at Standard Chartered Bank reckons foreigners will soon become the second largest buyers of Beijing’s debt, after Chinese commercial banks.
Yet GPIFs concerns are shared widely, behooving Xi’s team to raise China’s financial game and mind the geopolitics going forward.
What’s the drawback?
Chinese yields are plenty attractive. But as Miyazono’s GPIF team makes clear, perhaps not attractive enough considering the lack of a fully convertible currency and the presence of capital controls. The same goes for a relative dearth of liquidity in the secondary market. Beijing regulators have been slow to devise a world-class settlement system.
These concerns explain the slower-than-expected timeline for adding Chinese debt to the index. The six-month lag, what FTSE Russell calls a “more conservative” schedule, seemed aimed at prodding Xi’s market technocrats to act boldly, quickly and transparently to ensure the plumbing of the system is ready for China Inc’s big moment.
Geopolitical concerns also are filtering into the equation.
In private, GPIF officials fear a public backlash over financially backing a perceived human rights-abusing regime in Beijing. Last year, Denmark’s AkademikerPension divested from mainland bonds and stocks to protest China’s policies towards its minority Muslim Uighur population.
This same controversy is fueling debate about whether countries should boycott the 2022 Beijing Winter Olympics.
Uncertainties also abound about the trade war launched against China during Donald Trump’s presidency. Last year, Trump’s White House coaxed the Federal Retirement Thrift Investment Board to drop plans to incorporate Chinese equities into its portfolio holdings.
“It’ll be important for the fund to evaluate China’s risks properly by strictly focusing on its governance and its ability to service its debt,” says economist Takatoshi Ito at Columbia University, who once headed Japanese government efforts to reform the pension giant.
Adds strategist Ariel Bezalel at Jupiter Asset Management: “Political tension between the major Western economies and China on a range of issues is one of the concerns.”
China’s place in the sun
Even so, it makes perfect sense for Asia’s biggest economy to play its rightful place in capital markets via the FTSE Russell. “Not having the second-largest country in it was a gap,” says portfolio manager Binay Chandgothia at Principal Global Investors.
Pan Gongsheng, deputy governor at the People’s Bank of China, says the move will make it easier for the central bank to push for greater financial opening. “Going forward, we will continue to work to actively improve relevant regulations and policy arrangements and promote the further opening of China’s bond market to international investors,” Pan says.
Yet now the hard work begins.
As Chris Woods, head of policy and governance at FTSE Russell, notes, “we commend China on the great progress it has made in market reforms.” But, he stresses, “we will revisit progress on a regular basis and continue to work with the People’s Bank of China to ensure that its reforms continue to yield tangible improvements to market structure.”
That is easier said than done. China is taking a risk opening up to bond funds that might not find its underlying financial system up to the challenge. That means allowing for quick exits from yuan-denominated assets and boosting transparency to create the liquid and predictable market conditions bond funds demand.
It’s clear, though, that the moment for which Pan’s former boss Zhou Xiaochuan at PBOC prepared Beijing during his 2002-2018 stint as governor is here. It was at Zhou’s insistence that Xi’s government allowed the yuan to enter the International Monetary Fund’s special drawing rights program.
That imposed an unprecedented level of transparency on Beijing, including disclosing data on foreign exchange reserve levels. Until then, they were a national secret. It put Xi’s government on the spot with regard to exchange rate levels, forcing China to give traders a bigger say in the yuan’s value.
Yet this is the moment Xi’s reformers need to start walking the walk, not just talking of change. Since 2013, Xi’s Communist Party has talked a great game of letting market forces play a “decisive” role. Pension fund “whales” are about to get their closest look yet at whether China is ready for the waves of capital zooming its way.
Six months hardly seems enough time to build a globally trusted credit-rating system, roll out a wider variety of hedging tools, give regulators greater autonomy, allow for full exchange-rate convertibility and tolerate major debt defaults by irresponsible borrowers.
Xi-era paranoia about press and internet freedom also could unnerve the so-called “bond vigilantes.”
This rather acerbic gang of punters tends to take matters into their own hands to punish via high yields any government, monetary or corporate policies they consider counterproductive or dangerous.
Their ability to jack up borrowing costs and get governments’ attention can be seen in a recent series of weak US government bond auctions. The bond vigilantes are warning President Joe Biden’s White House to tread carefully with the size of fresh economic stimulus packages.
The costs of Xi’s media strategy in this regard are impossible to calculate. China has become even more of a black box on his watch, adding to concerns at GPIF headquarters in Tokyo. Opacity can often be expensive, particularly if it obscures the onset of a so-called “Minsky moment” in China.
The reference here is to the moment a debt and credit-fueled boom meets a nasty end. Every industrializing nation runs this risk. And such dislocations tend to appear out of nowhere: Japan in 1990; Mexico in 1994; Southeast Asia in 1997; Russia in 1998; Lehman Brothers in 2008; the “taper tantrum” in emerging markets in 2013.
Given China’s track record of steering clear of crises, this may indeed be a manageable risk. China is the Covid-19 growth champion, expected to expand a world-beating 17.9% in the January-March quarter. That puts Xi’s economy on path to surpass US gross domestic product by the early 2030s.
Yet if Xi’s team doesn’t use the six months ahead of formal FTSE Russell inclusion to raise its financial game, it risks blowback in international markets.
Some of the biggest players in the bond game, including Bridgewater Associates founder Ray Dalio, are urging investors to up their Chinese bond holdings.
As Dalio puts it: “The cycle of becoming a reserve currency, over-borrowing, and being over-indebted threatening the reserve currency status is classic. As part of this cycle there is the emergence of the currency and capital markets of the rising and competing empire. Consistent with this classic cycle, there is now a shifting from US bonds to Chinese bonds going on.”
The change dynamic is clearly on China’s side. But underlying market conditions matter, too. As GPIF, Dalio and peers increase their exposure to China, they won’t be timid about decrying deficiencies they encounter.
Any concerns about transparency, securities settlements, the ease of identifying counterparties or regulatory troubles that belie Xi’s pledge to let market forces play a “decisive” role will be the talk of the bond business. It’s a safe bet they will air their concerns and criticism via Twitter, television hits on CNBC, Bloomberg, Fox Business and elsewhere.
Six months is a short window to prepare for the globe’s bonding experience with China. Xi’s team has its work cut out to validate the optimism of the bond bulls.