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China’s corporate bond market is the second largest in the world. However, due to regulation which restricted market access, it was previously unavailable to foreign investors, and therefore remains largely untapped. The market is now starting to open to foreign investors, which should prove a major step in the development and maturation of the market. In our view, this presents a significant opportunity for investors.
At the same time, China’s economy is undergoing a significant transition, resulting in a moderation in its rate of economic growth. While this is causing some concern among investors, the bond market can benefit from a more moderate growth trajectory.
China’s economic growth rate has been one of the most keenly watched indicators for many years now. In the mid-2000s, China saw consecutive years of +10% growth. A remarkable and unsustainably high rate. Since then, the economy has steadily slowed down. China recently reported its slowest economic growth rate in 28 years at 6% year-on-year in Q3 2019.
While a slowing economy is generally undesirable, it can be beneficial to bond market investors, especially in the absence of inflation. A slowing economy generally forces central banks to ease monetary policy, usually by lowering interest rates. As interest rates are lowered, bond prices rise – particularly government bond prices.
Theory holds that if central banks ease monetary policy, the cost of lending falls, encouraging companies and individuals to borrow and subsequently spend. This helps the economy regain its footing as activity increases.
The Schroders China Activity Indicator would suggest China’s lower growth is here to stay (Figure 1). However, the authorities are aiming to contain economic weakness through increased spending and easier monetary policy via lower interest rates. This activity should support bond investors.
Over the medium term we anticipate that Chinese economic growth will stabilise, just at a lower level than in the past. For the time being, with China in this state of transition, the risk is that the naturally lower rate of growth could decelerate. The authorities are determined to avoid this. As such it will likely be some time before a meaningful tightening cycle is viable. This could provide a solid foundation for Chinese bond markets.
We identify a number of factors behind this slower expected growth rate:
- Economic re-orientation: China’s policymakers are re-engineering their economic model, away from manufacturing and exports to domestic consumption and services. Such significant change is likely to cause economic activity to slow in the near-to-medium term as resources are shifted from established industries to nascent ones.
- Debt deleveraging: The Chinese state-owned enterprises (SOEs) and local government authorities have racked up significant debt since 2009. More recently, Chinese policy makers have been implementing policies to force these entities to reduce debt instead of continuing to spend. Hence, a major contributor to economic activity has been curtailed.
- Sino-US trade tensions: Trade tensions have significantly increased between China and the US. This is dampening sentiment in China, as well as globally, weighing on corporate profits. Tariffs from both countries have increased costs for firms, impeding economic activity. A full-blown trade war between the US and China would be even more damaging for both countries and is not our base case.
- Demographics (a long-term factor): China’s demographic dividend is waning. It is well known that China is the most populous country in the world, providing a workforce that has powered its economy into the second largest in the world, behind the US. This workforce is now ageing while the birth-rate is now too low to make up for the workers heading into retirement in the future. Research by the International Monetary Fund shows that in countries with weaker demographics, inflation adjusted interest rates tend to decline; a factor supportive of bond prices (Source: IMF, April 2017).
- Technology (a long-term factor): Rapid technological advancement is also expected to impact growth. Technology can improve economic productivity while at the same time reducing the need for more workers. This limits wage costs pressure as workers cannot demand higher wages if machines are performing tasks at a lower cost. There is even the potential for headcounts to be reduced, which could lead to stagnant wages and a negative knock-on effect on growth and inflation.
The onshore Chinese bond market (bonds issued in China denominated in renminbi) is the third largest bond market in the world, and only narrowly behind Japan’s in second. However, Chinese bonds are under-represented in investment portfolios and global bond indices.
International investors’ allocation to Chinese bonds is low because historically they have been excluded from investing in the market by the Chinese authorities.
However, over the last ten years the market has become more welcoming of foreign investors. Indeed, since April 2019 domestic Chinese bonds have started to be phased in to the Bloomberg Barclays Global Aggregate index. Since then, JP Morgan has announced that it will start to include Chinese government bonds in its Global Sovereign and EM local currency indices. We anticipate that FTSE, the other major bond index provider, will follow suit in the near to medium term. Flows into the Chinese government bond market in particular, have now exceeded $228 billion as at September 2019.
The Chinese bond market is also diverse, offering options across the risk, and return, spectrum. Notably, government bonds do not dominate the onshore Chinese bond landscape unlike in most advanced economies.
The government bond market can offer an attractive option for investors looking to diversify their risk, especially as it is reasonably uncorrelated with most developed and emerging market bonds.
With the broader economic conditions moving arguably in favour of bond markets and regulatory change opening the markets to a wider investor base, we think a key moment is approaching for Chinese fixed income.
A rise in interest rates generally causes bond prices to fall.
A decline in the financial health of an issuer could cause the value of its bonds to fall or become worthless.
Changes in China's political, legal, economic or tax policies could affect the performance of Chinese government bonds
 Correlation is the degree to which two financial securities or markets move in the same direction.
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