Foreign investors have not been shy of hyperbole in lauding the inclusion of Chinese government and policy bank bonds into the Bloomberg Barclays Global Aggregate Bond Index. One declared it a sign that “tomorrow has come” while others whipped out standard descriptions such as “a significant milestone” to describe the event. A bit drab, but that is what often passes for unbridled enthusiasm among bankers’ official pronouncements. Chinese bankers, however, were confused by the excitement of their offshore counterparts.
For them, the index inclusion, at least in the short-term, will increase foreign investment in the onshore bond market but only to very little from a level of virtually zero.
They also pointed out that foreign investors already have many access channels to both the primary and secondary bond markets in China. Even the newest channel, Bond Connect, has been around since 2017.
Foreign investors already hold 8.2% of Chinese government bonds and 2.6% of policy bank bonds. Last year, they bought half of new Chinese government bond issues. It is the corporate bonds that they have largely avoided, and those are not within the scope of the index inclusion.
Finally, they said that index inclusion could not solve one of the key concerns foreign investors have for the Chinese bond market – that China’s big state-owned commercial banks do not provide the liquidity for them to trade in and out of the securities.
That’s not likely to change, at least in the short term. Chinese commercial banks held a total of 68% of Chinese government bonds, 61% of policy bank bonds and 68% of outstanding overall onshore bonds at the end of February, according to data from China Central Depository and Clearing.
One onshore banker summed up the index inclusion as merely a nice “gesture”. However, as gestures go it is a big and important one, and is likely to grow in its impact on global markets, for four reasons.
First, the gesture is a powerful one. While analysts anticipated $120bn-$150bn of foreign inflows as a result of the index inclusion, those numbers only account for passive inflows. The amount of active inflows could quickly reach as high as as $3tr, one fund manager estimated.
Second, there may be more gestures coming. Bloomberg is only the first index provider to include Chinese bonds in a big global index. Both FTSE Russell and JPMorgan have expressed interest in doing so too. Bloomberg has also indicated that Chinese corporate bonds and Chinese ABS notes may also be added in the coming years.
Third, China has maintained an overall bond market growth above 15% for the past 10 years, according to Wind data. The overall Chinese bond market reached Rmb85.7tr ($12.8tr) in 2018. If this keeps up, China will become the world’s second biggest bond market, surpassing Japan.
As a comparison, the growth of the US bond market runs at a slower pace of around 2%-5%, reaching $43tr in 2018, according to Sifma, a US securities industry trade body. Japan’s domestic bond market shrank by 2.9% in the third quarter of 2018, according to the Bank for International Settlements.
Lastly, demand for Chinese government bonds will also boost the demand for the renminbi. In 2018, the currency surpassed the Canadian and Australia dollar to become the fifth most-used currency in FX reserves held by central banks, taking up 1.89% of the total FX reserves, according to a report by the International Monetary Fund.
But if global money is to flow into Chinese bonds in size, there are obstacles to be overcome. China will have to keep opening up access to its markets, ease strict onshore capital controls, and encourage the culture and behaviour in its markets to suit more cautious western sensibilities.
There are still many unknowns when it comes to investing in China that would deter investors awash with opportunities from all over the world. Forcing investors into China by way of index inclusion will help overcome some of them. It is not so much about knowing the unknowns as owning them.
There is much to do if global money is to light up Chinese bond markets. If tomorrow really has come it is still the wee small hours of the morning and it is still pretty dark out there.