FTSE Russell announced these changes to its World Government Bond Index (WGBI) on 25 September. Inclusion of Chinese government bonds (CGBs) will start next year, subject to final confirmation. The move brings the company in step with the compilers of the Bloomberg Barclays Global Aggregate Index, and the J.P. Morgan Government Bond Index - Emerging Markets.
More international investment in China seems counterintuitive in these troubled times of mounting US-China rivalry. This is a strategic rivalry that will lead to further decoupling for the world’s two largest economies, raising hurdles to trade and investment. Ahead of one of the most contentious US presidential elections in living memory, the need for a tougher stance on China seems to be the only issue that Democrats and Republicans agree on.
That said, we have seen strong interest from international investors, such as sovereign wealth funds and Australian superannuation funds, in renminbi-denominated CGBs. Interest has pushed foreign ownership to record levels, albeit from a low base. Foreign investors accounted for some 2.8 trillion yuan (US$413.8 billion) of the 110 trillion yuan market, as of end-August.
Investors in Europe, Latin America and Australia, have extended their existing interest in A-shares – those listed on mainland China’s stock exchanges – to the country’s government bonds. These investors recognise the relative value on offer. For example, 10-year CGBs yield 3.12 percent compared to the 0.67 percent from dollar-denominated 10-year US Treasury bonds.
Yields are higher even though China looks as if it will be the first major economy to rebound from the pandemic-induced lockdowns that have battered growth this year. China’s monetary policy is shifting back towards a focus on financial stability (as opposed to stimulus). In recent months, tighter monetary policy – restricting the supply of money within the financial system – has pushed Chinese bond yields above pre-pandemic levels. By contrast, yields in other major bond markets have been pushed lower by monetary expansion in those jurisdictions.
Granted, relative yields may not look as attractive after hedging costs from buying financial instruments to mitigate currency risk are included. But the additional yield offered by CGBs versus the government bonds of developed markets provides a buffer against further market volatility. This is not the case in the mature economies where interest rates are already close to zero, government bond yields are negligible and central banks are running out of options with regards to monetary policy.
China has a big incentive to keep the renminbi stable. The value of the yuan has been allowed to fluctuate more in line with market forces since 2014, as China wants its currency to play a bigger role in international trade and investment. Even so, it trades within bands set by policymakers who try to dampen any excessive volatility. A sharp depreciation of the yuan would feed accusations of currency manipulation, amplifying existing tensions with the US.
Meanwhile, the People’s Bank of China, the country’s central bank, has the tools to offset any liquidity drain should foreign investors suddenly pull out of the bond market. State direction within the banking system remains a powerful policy lever which can help support bond prices in the event of market disruption caused by capital outflows.
So far, the bond market has escaped the overseas scrutiny and censure directed at Chinese companies in the equity markets. It is conceivable that the spotlight may eventually swing towards CGBs, should the US-China relationship deteriorate even further. However, equity investments will likely remain more sensitive given the politics around the issue of reshoring – the return of manufacturing back to a company’s country of origin.
In fact, our multi-asset colleagues think that CGBs offer the best hedge against A-shares. CGBs and A-shares can be used to mitigate risk for one another in the short-term, while generating positive potential returns over the long-term. The relationship is not unlike the historical relationship between the S&P 500 and US Treasury bonds.
There is a risk that markets underestimate (or struggle to price appropriately) the deeper structural decoupling that is taking place between the US and China. This is a long-term process which will have implications for globalisation, capital flows and technology development.
However, Chinese government bonds remain relatively insulated. While the inclusion of these securities into the WGBI will lead to more passive investment, there are plenty of better reasons for investors to sit up and take notice.
Edmund Goh, investment director, fixed income – Asia, Aberdeen Standard Investments