Commentary on Political Economy

Sunday, 22 November 2020



China Opens Its Bond Market—With Unknown Consequences for World

The nation’s entry into the World Trade Organization rocked global commerce. The financial markets could be next.

Illustration: Sija Hong for Bloomberg Markets
Chris Anstey
Enda Curran

China’s 2001 entry into the World Trade Organization transformed the global economic order. Yet even as China became the factory to the world, its financial system remained a closed shop, with strict controls on the flow of money in and out. For years there’s been talk of a “two-way opening,” but slow progress. Now the admission of foreign investors into China’s $15 trillion bond market—cemented this year when the country rounded out its inclusion in all three of the top global indexes—may just mark the big bang equivalent to WTO entry.

Global pension funds, starved for yield in a low-growth world, will now have access to safe government debt that pays more than 3%. And if officials deliver on their pledges to open up, reinforced in the Communist leadership’s 2021-25 five-year plan outlined in October, Chinese investors may soon find it a lot easier to snap up shares in Apple, Starbucks, or Tesla—not just their phones, cappuccinos, and cars. The Chinese could join their government, which has long been a major buyer of overseas assets such as Treasuries, as a powerful source of funding.

“China will turn from an exporter of goods to an exporter of capital, with significant consequences, of course, for the world,” says Stephen Jen, who runs Eurizon SLJ Capital, a hedge fund and advisory firm in London.

Bloomberg Markets
Featured in the Dec./Jan. issue of Bloomberg Markets Illustrator: Kristina Collantes for Bloomberg Markets

But what will the consequences be? Major changes to the financial system in the past have produced some unfortunate results. The euro’s 1999 introduction sowed the seeds for the region’s debt crisis a decade later. A wave of overseas savings that poured into the U.S. during the 2000s helped trigger the mortgage boom that catastrophically burst in 2007‑08. Bloomberg Markets gathered views on how the opening might affect the future of global finance in the years ahead. Here are some of the themes that emerged.

Chinese Savers Go Global

Jen, who started his career at Morgan Stanley covering the impact of the Asian financial crisis on the foreign exchange market, sees China’s capital market opening as the biggest structural change to international finance since the launch of the euro.

Sustained inflows of foreign capital could make Beijing comfortable about loosening the controls that have bottled up domestic money in China for so long. Indeed, it would probably have to; otherwise the yuan would strengthen, eroding the country’s export competitiveness. That would let loose a wave of Chinese savings on the world—Jen estimates there’s as much as $5 trillion of pent-up Chinese demand for investments outside China. That could resemble the petrodollars that flowed from oil-exporting countries in the 1970s, which ended up financing a huge, and tragically unsustainable, borrowing spree by Latin American nations.

“Outflows will probably be offset by the inflows for a few more years,” Jen says of China. Petrodollar-like net outflows might take a few more years to materialize, “but that is definitely a scenario we will need to deal with,” he says.

A Slice of the Action

To gain exposure to China’s rapid economic expansion, global investors generally have had to buy proxy assets such as the Australian dollar, commodities, or a small range of Hong Kong-listed Chinese shares. China’s bond market opening gives them direct exposure. It also provides an alternative to Japanese government bonds and other low- or negative-yielding sovereign debt, says Ed Al-Hussainy, a senior analyst for global rates at Columbia Threadneedle in New York, which had $476 billion under management in October and has been stepping into the China market recently.

“The demand is off the charts for anything liquid with a little bit of pickup in yield over Treasuries,” he says. “People are willing to pay up for liquidity, and that’s the key thing that’s improving in the Chinese onshore market. So inevitably we’ll be pushed in that direction.”

China’s central government bonds are now included, or on a phased path to inclusion, in the three key international bond indexes that investors use as benchmarks compiled by FTSE Russell, JPMorgan Chase, and Bloomberg Barclays (part of Bloomberg LP, the owner of Bloomberg Markets). About $5.3 trillion in assets tracks these indexes, according to estimates from Goldman Sachs Group Inc. Passive index-tracking funds will need to buy Chinese bonds to match the benchmarks. Some active managers, concerned about transaction costs, may steer clear; others are likely to overweight China because of the attractive yields.

Flow on Effect

China’s bond yields look more like those of emerging markets—in the FTSE World Government Bond Index benchmark they will be second highest after Mexico’s—yet investors will probably view them as developed-market securities, Goldman analysts say. After pulling in $230 billion from foreign investors to its fixed-income market in the past five years, China will see about $770 billion more in the next five, Goldman analysts including Kenneth Ho estimated in October.

A Class by Itself

Market players don’t expect the resulting shifts in asset allocation to increase bond yields much elsewhere—but the money will need to come from somewhere. Overseas investors held almost 13% of Japanese government bonds and more than 30% of Treasuries at the end of June. About one-quarter of euro region government bonds are held by investors outside the currency union, according to estimates from Commerzbank AG.

“We have a huge overhang of JGBs and European bonds—and a lot of that is dead weight,” says Columbia Threadneedle’s Al-Hussainy.

Competitor for Capital

Washington, in particular, could find itself competing with Beijing for overseas capital. China’s current account is barely positive relative to the size of its economy, even with its large trade surpluses with the U.S. It runs vast deficits in the trade of services, and some economists predict it will in the future run current-account deficits. If that happens, China would need to pull in money from abroad, just as the U.S. has for decades.

“China could enter structural current-account deficits, which will force it to open the market and import capital from abroad,” says Aidan Yao, a senior economist at AXA Investment Managers in Hong Kong who previously worked for the Hong Kong Monetary Authority. With China and the U.S.—sometimes referred to as the G2—both competing for savings, “either the rest of the world has to step up savings to finance G2’s shortfalls, or G2 will have to adjust themselves,” Yao says.

Competition could be all the fiercer if Washington expands on moves in 2020 to reduce Chinese borrowers’ access to American capital. Lawmakers from the Republican and Democratic parties have both proposed rules that would make it tougher for China’s companies to issue stock in the U.S., for example.

“The harder the U.S. tries to isolate China, the more efforts China should make in opening up,” says Yao Wei, chief China economist at Société Générale SA in Paris. “Allowing in more foreign investments will further deepen China’s integration into global financial markets, which will make decoupling more difficult.”

Better Credit Allocation and Transparency

Chinese regulators hope that opening their bond market will improve how credit gets allocated. The nation’s Communist leadership has sought to transition the economy to a more market-based system in which investors and credit analysts price funding for different borrowers according to their risk. Policymakers hope that will stem the buildup of stressed and defaulting loans, reduce excess capacity, and result in more productive investment.

That helps explain why the People’s Bank of China and other regulators worked so hard to win acceptance into the benchmark bond indexes. That approval required addressing a wide variety of complaints about the local market, such as the excessive paperwork required from foreigners and the slow pace of trade completion. Regulators also provided more hedging options, and the government boosted the size of individual bonds to increase their liquidity. After a messy 2015 yuan devaluation, the PBOC has also tried to reassure overseas investors by conducting exchange rate management with greater transparency and stability.

The Chinese Communist Party’s five-year plan, outlined in October, recommitted to opening up. Han Wenxiu, a senior official involved in drafting the plan, said at a briefing that “China will see the scale of foreign trade, foreign capital utilization, and outbound investment continue to expand.” PBOC Governor Yi Gang has also highlighted the value of financial opening, saying it improves efficiency and aids higher-quality economic development.

QuickTake: China’s Finance World Opens Up to Foreigners, Sort Of

“Foreign institutions can be a source of fresh blood that can introduce innovative and mature ways of doing business to the local market, which has long been dominated by Chinese banks and brokerages,” says Becky Liu, head of China macro strategy at Standard Chartered Plc.

Unintended Consequences

There’s always a risk that things won’t go as planned. For instance, what if, instead of disciplining the Chinese fixed-income market, the opening gave China’s riskiest borrowers even cheaper credit?

Here’s how that might happen: Foreign investors stick primarily to buying bonds sold by the central government and three state-owned lenders known as policy banks that are closely associated with government objectives. As of mid-2020, overseas managers held 8.5% of central government bonds, up from just 2.4% in February 2016. By contrast, their share of corporate bonds, at 0.7%, was barely changed from 0.6%, Goldman analysts estimated.

“The authorities may end up with domestic investors who are being crowded out of the government bond market,” says Michael Spencer, chief Asia-Pacific economist at Deutsche Bank AG in Hong Kong. “By pushing down yields on the risk-free assets, these foreign inflows may be forcing the Chinese investors even further out the credit curve. So if you think they are not very good to begin with in pricing credit, then these inflows actually may be making that problem worse.”

Spreads across China’s domestic corporate debt market are less differentiated than in the U.S. bond market. Top-grade corporate bonds yielded about 70 basis points, or 0.70 percentage point, more than China’s government bonds in late October. High-yield securities had rates 329 basis points higher, according to the ChinaBond platform. By contrast, investment-grade U.S. corporate spreads were at 123 basis points over Treasuries and junk bonds had a 488 basis-point premium.

Record Holdings

Losing Control

The more open the market is, the more difficult it will be for Chinese policymakers to maintain their grip on interest and exchange rates. Moves that drive up yields—such as monetary tightening to control inflation—could spur a wave of inflows that sends the currency climbing, making exports less competitive. Similarly, measures that undermine the confidence of overseas investors could prompt a destabilizing exodus.

China’s policymakers are cautious and patient. That helps explain why they kept the financial system cordoned off even as they opened the economy in myriad other ways starting in the late 1970s. They welcomed investment in manufacturing, but portfolio inflows were another matter. After all, emerging-market crises in the 1980s and 1990s showcased the danger of “hot money” that can quickly exit a country, causing wrenching financial turmoil.

“With an open financial market with easier inflow and outflow, the Chinese government and central bank will have to be more cautious managing those funding costs and interest rates,” says Lu Ting, chief China economist at Nomura Holdings Inc. in Hong Kong. “And of course, it will make it more challenging to manage the exchange rate.”

China might need to reestablish controls and limits if the financial market opening spurs excessive volatility. Authorities in recent years have managed swings in the currency by introducing or removing curbs on the foreign exchange market. So while China’s policymaking elite seemingly agree on the benefits of opening, the process is likely to be a stop-start one.

Pros Outnumber Cons

China wants and needs overseas capital to fund its growth and promote the global use of its currency, which remains a bit player in international transactions. The country’s growth rate has steadily decelerated in recent years, even before the pandemic, and the era of outsize current-account surpluses is over. With an aging and shrinking labor force, China risks falling into the “middle-income trap”—stagnating before it reaches rich-world levels of development. Improved financial transparency, a diverse funding mix, and more productive investment will be key to ensuring that doesn’t happen.

For the rest of the world, China’s financial integration will bring unpredictable change, just as the country’s entry into the global trading system did. Its giant labor force made goods more affordable around the world, improving the lives of millions. But it also hollowed out manufacturing towns from Michigan to northern England, imposing social costs with political consequences that are still playing out. Similarly, the coming shift of trillions of dollars of capital across borders seems likely to create winners and losers around the globe. —With Tian Chen and Katherine Greifeld

Anstey is a senior editor in Boston, and Curran is chief Asia economics correspondent in Hong Kong.

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