Chinese fixed income: Policy is key

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The liberalisation of the Chinese financial market has been a relatively recent phenomenon, triggered among other factors by the abandonment of the peg to the dollar in 2005, followed by an appreciation of the renminbi (RMB).

he Chinese bond market can roughly be distinguished between onshore and offshore products, with the onshore RMB trade of more than RMB21trn (€2.7trn) constituting the vast majority, compared to a small, yet rapidly growing offshore market.

In a bid to boost the internationalisation of the RMB, Chinese authorities have increasingly eased capital account barriers. According to Deutsche Bank, funds in the key offshore RMB centres, Taiwan and Singapore have increased sharply. As of December 2013, offshore funds in Taiwan trebled to RMB184bn (€23.7bn) while funds in Singapore increased to RMB140bn (€18bn). According to the City of London, RMB forex activity in London tripled between 2011 and 2013 to a daily value of $4.8bn (€3.8bn).

European fund distribution centres are now competing to align themselves with the People’s Republic, with Frankfurt and London becoming the first European RMB clearing hubs, Luxembourg attracting the Industrial and Commercial Bank (ICBC) and London the China Construction Bank as respective RMB clearing centres.

In Germany, investments in the RMB have become an increasingly popular method of escaping low returns in the fixed income sector, explains Torsten Harig, director and senior product specialist fixed income at Deutsche Asset & Wealth Management (DeAWM).

APPRECIATION CHALLENGE

The driving force behind investments in the “People’s Currency” as the RMB is referred to in China, is the anticipation that the currency will continue to appreciate. This represents a challenge for Chinese growth, which has historically been
largely export-led. However, according to Adeline Ng (pictured), head of Asian Fixed Income at BNP Paribas: “China is undertaking structural reforms in order to transform itself to become more consumption driven and less reliant on exports.”

“The Chinese government is sending out a very strong signal even with the euro weakening that we are ready to still maintaining an appreciation bias for our currency,” says Thomas Kwan, head of fixed income at Hong Kong based
Harvest Global Investors. “The recent popularity of online retailer Alibaba’s IPO is a good indication of the potential of domestic demand inChina,” argues Kwan.

Yet investors were concerned when the Chinese government sought to devalue the RMB marginally against the dollar earlier this year. Both Kwan and Ng emphasise that this devaluation was not an attempt to boost exports, but to prevent the RMB from becoming too successful for its own good, as concerns over currency speculation have increased.

Overall, RMB volatility remains relatively low. Between 2000 and 2014, offshore China RMB bonds had an annualised volatility of 3.4%, compared to annualised volatility of 6.9% across sovereign bonds generally.

An interesting aspect of the growing RMB popularity is the correlation with unconventional monetary policy measures in the US, UK and Europe (see chart, left). As liquidity increases and fixed income returns decline, investors arelooking for Chinese fixed income as an opportunity to find yield.

Yet this raises the question, what happens if central banks proceed to wind down tapering, as is widely anticipated? According to Ng: “The impact of the end of the Fed’s  tapering and the upcoming normalisation of US monetary policy will have limited impact on Chinese fixed income markets as the two monetary policies have a low correlation due to their different drivers.”

DEFAULTS
Another key concern for investors is the lack of transparency and an increased number of reports on default risks, both on the sovereign and corporate debt side.

Like many other countries, China has seen a stark rise of sovereign debt as a result of the 2008 financial crisis and yields, with debt levels of 45% of GDP in 2012 according to the IMF, Chinese sovereign debt remains lower than that of most developed economies. However, with GDP growth set to slow down, this ratio is likely to increase.

As for regional sovereign debt, analysts have spotted correlation between shadow banking activities and fiscal deficits in China’s provinces. According to BNP Paribas and the People’s Bank of China, provinces with the highest level of shadow banking activities such as Tibet and Guizhou have highest provincial fiscal deficit ratios at 115% and 25% respectively.

The corporate sector has been hit by a series of defaults and market corrections, starting with the property sector, which is set to decline between 5 and 10%. Similarly, cement prices have plummeted by 20% since January 2014. At the same time, the state response to China’s first corporate bond default, that of Shanghai Saori Solar in 2014, suggest that the government is prepared to bail out investors.

“The selloff in Chinese asset markets in Q1 was not about slower GDP growth rates, it was about fears of a property market crush and/or a blow up of trust products,” says Thomas Kwan. Consequently, “slower GDP growth rates due to the rebalancing of the economy would not be negative for China asset markets. What we are going to see over the next two or three years is a process of adjustment focusing on long-term growth drivers for the Chinese economy and we believe the
market have started to appreciate it,” he argues.

Yet, an immediate challenge to these reforms is represented by the political unrest the country has been facing, including the protests in the Special Administrative Regionof Hong Kong. In the short term, protests in Hong Kong, a leading offshore RMB centre, could arguably have contributed to the currency weakness, which it hit a six month low as of late September.

However, fixed income market should not be directly affected by the protests, argues Ng. The Chinese government still aims to establish the RMB as the third largest international currency.

“In the end, China is just too big to be ignored,” Kwan concludes.

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