Following the introduction of China – Hong Kong Bond Connect in July 2017, we have recently witnessed another important milestone in the long-term liberalization of China onshore bond market, i.e., the inclusion of China’s sovereign and policy bank bonds into the widely tracked Bloomberg Barclays Global Aggregate Index. The inclusion will be implemented over a 20-month period starting April 2019, and the process is expected to be slow and gradual. Upon completion, 364 Chinese securities will account for 6.1% of the $54.9 trillion index and the yuen-denominated debts will then form the fourth-largest currency component behind the dollar, euro and yen in the index. Among the 364 bonds that will be included in the index, the mix will be as follows:
– Chinese government: 159
– China Development Bank: 102
– Agricultural Development Bank of China: 58
– Export-Import Bank of China: 45
The move is critical and meaningful to both China government and global investors as it would be an important step to integrate Chinese markets in the global financial system and help advancing RMB internationalization. Besides, it helps to diversify China’s sources of funding, and China needs foreign capital to finance its slowing economy in particular as the country’s current account is expected to swing into a deficit in the coming years. China is now gradually transforming into a more service-oriented economy, and would have a high tenancy for imports, putting additional pressure to its trade deficit onwards.
On the other hand, China onshore bonds market is a massive $13 trillion debt market, the world’s third-largest after the U.S. and Japan, and this’s a market that foreign investors should not be missed. In fact, China onshore bonds offer global investors a meaningfully higher yield than other major markets. For example, China’s 10-year government bond yielded at about 3.1%, compared with 2.4% on equivalent US, 1% on UK and 0.4% on France sovereign notes respectively. In addition, China onshore bonds, which has been dominated by domestic investors, could offer considerable diversification benefit to foreign investors and help them to reduce their portfolio volatility as the correlation between Chinese bond and US Treasury prices has been almost zero over the past few years. However, this benefit may gradually diminish as foreign investors participation in China’s bond market rises over time.
Meanwhile, foreigners’ share of China bond market is about 3.4% only, but it is growing exponentially from less than 2% last year ($248bn in 2018 and $183bn in 2017). In fact, the average daily trading volume on the China-HK Bond Connect increased to RMB5.9bn during 1Q19 compared to RMB3-4bn in 2017 and 2018, and is likely to exceed RMB7.5bn on April per our estimate. Another measure of foreign participation, i.e., the number of registered international institutional investors in Bond Connect Scheme, have increased to 711 at the end of March 2019 (vs. 500 at the end of December 2018), reflecting foreign interests in China bonds is rising drastically. With index inclusion starting April 2019, it could provide another boost to the transaction volume on Bond connect and may bring passive inflows of $120-$135bn to the China onshore bond market, according to Citi and Goldman Sachs forecast.
Source: Bond Connect Company Limited, Noble Apex/iFund
In overall, we see China’s inclusion in global bond benchmarks is a key event to global investors, which is equally as important as the increase of inclusion factor of China A shares in the MSCI index. Looking forward, China still have to put much more efforts to further open up its debt market, such as the needs of developing more interest-rate derivatives that meet the hedging needs of foreign investors as well as the importance of having a more recognized and reliable credit ratings system as comparable to international standards. We believe China bonds would become a very important asset class for global investors in future, especially corporate bonds remains heavily under-penetrated, with international investors accounts for less than 1% of the total corporate bond at present.