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Outlook for china local currency debt

February 2020

Chinese onshore bonds: going mainstream

The inclusion of renminbi-denominated debt in the flagship global benchmark bond index will transform the asset class into a strategic investment.

For all the turmoil caused by the coronavirus, one corner of China’s financial market could prove surprisingly resilient: local currency debt. 

This is because the country’s onshore renminbi (RMB) -denominated bonds are about to be included in JP Morgan’s flagship emerging market bond index for the very first time.

This is a landmark moment, both for China and for investors worldwide.

For authorities in Beijing, it's a stamp of approval for their efforts to liberalise the country's capital market and integrate more into the international financial system.

For investors, it opens up a new world – one where the RMB becomes a genuinely global investment currency. In a matter of months, China's USD13 trillion onshore bond market will play a far greater role in bond portfolios.

RMB bonds and reserve currency

Foreign ownership of Chinese bonds was already rising in anticipation of the index change, which the International Monetary Fund expects to result in capital inflows of as much as RMB7.4 trillion.

Non-Chinese investors built up their holdings of RMB debt to RMB2.2 trillion by September 2019, up from RMB700 billion in mid-2017. Foreign central banks and sovereign wealth funds account for the biggest share with 58 per cent of that total - asset managers and commercial banks currently hold 20 per cent1.

Thanks to central bank purchases, the RMB is now the world’s fifth largest reserve currency, making up just under 2 per cent of the total foreign exchange reserves. If that share were to double, it would amount to an additional RMB1.5 trillion of RMB bond investments, the IMF says. According to Pictet Asset Management's economists, it won’t be long before the RMB’s share of international reserves is greater than that of the British pound2.

Inflows from private investors will also expand rapidly as other index providers follow in the footsteps of JPMorgan to incorporate the asset class into bond benchmarks.

Index inclusion also brings into relief the asset class's positive attributes at a time when a large volume of bonds – in developed and some emerging economies – yield below zero.

The yield on five-year Chinese government bonds stands at 2.8 per cent, compared with 1.4 per cent for US Treasuries, -0.1 percent for Japanese Government Bonds and -0.6 per cent for German Bunds with the same maturity3.

Yield is not their only selling point. They also offer diversification. The returns of RMB bonds do not correlate especially strongly with any major global asset class – bond or equity. The correlation of RMB bond returns with those of US and European bonds and equities is less than 0.34.

Add in the currency's potential for appreciation over the long run (see our previous article) and investors will find the market difficult to ignore for long. 

Burgeoning asset management industry

Already, global asset managers are becoming a significant source of investment flows into the RMB bond market. In the first eight months of 2019, they vaulted public sector investors to become the largest net foreign buyers of Chinese onshore bonds, accounting for 51 per cent of net bond purchases – or RMB110 billion in nominal terms5.

Making it easier still for foreigners to access the market is the “Bond Connect” programme, which has allowed non-Chinese investors to trade in Hong Kong without an onshore account since its launch in 2017. The programme’s trading volume has risen nearly 200 per cent in 2019 to RMB2.6 trillion6.

Policymakers are also keen to attract foreign funds to hasten the development of a home-grown asset management industry.

This is a priority for China as the country’s rapidly aging population demands a sustainable pension system. China’s asset management industry – fund houses, insurers and securities and trust companies – is expected to triple in the 10 years to 2028 to RMB47.3 trillion as Beijing is set to remove all foreign ownership restrictions later this year.7

This should also help broaden the domestic institutional investor base currently, which is currently dominated by commercial banks.

Opportunities multiply
AUM growth of China's asset management industry by asset class, RMB trillion
AUM growth of China's asset management industry by asset class

Source: iFinD, Roland Berger

More policy easing

The RMB debt market’s elevation to international status comes at time when monetary conditions at home are particularly favourable.

The People’s Bank of China has cut the reserve requirement ratio – or the amount of cash that all banks must hold as reserves – eight times since early 2018 to arrest an economic slowdown. Earlier this month, the PBOC lowered the interest rates on reverse repurchase agreements and injected more liquidity into money markets to relieve pressure on the economy from the coronavirus outbreak.

We expect monetary conditions to ease further. Measures designed to support struggling industries should form part of the policy mix.

It’s been a tough start, but the Year of the Rat still promises to bring strong growth for the onshore RMB-denominated debt.