The Eastern Migration

03 Oct 2016

Key takeaways

  • For bond investors, there has been a gaping hole on the map.
  • This year, all quota restrictions on foreign investors were lifted in China.
  • Obstacles still need to be addressed in order to secure China’s preeminent place in investor portfolios

Full commentary

For bond investors, there has been a gaping hole on the map. Two of the largest bond markets in the world have not been readily accessible to foreign investors: China and India. The cumbersome quota system of India and the complex capital controls of China have, until recently, kept most foreign investors at bay. As a result, the emerging Asia opportunities have been considerably under-represented in the global bond indices.

China, in particular, has long been the elephant on the trading floor. With a market capitalization of USD 8 trillion, China has represented the most under-owned and under-traded market by global investors. Even today, China represents only two percent of foreign bond portfolio ownership.

This year, all quota restrictions on foreign investors were lifted in China. While full representation of the Chinese bond markets in fixed income indices are likely to take some time due to the further progression of necessary regulatory changes, the Chinese onshore bond market may be on the cusp of benefitting from a wave of foreign interest. It now appears attractive and is one of the most exciting investment opportunities in emerging markets.

Growth has impressed recently. However, with a market capitalization of 65% of gross domestic product (GDP), China still presents ample room to grow compared to developed markets, which are already in excess of 200% of GDP. With an expansionary fiscal policy, sharply rising provincial and infrastructure bonds issuances, and a strong commitment to deepen its local financial markets, the Chinese bond investment universe should gain in both breadth and liquidity. Additionally, the opening of the onshore bond market to foreign institutional investors – the so called “interbank” market – is a major milestone in capital account and interest rate liberalization.

However, a few obstacles still need to be addressed in order to secure China’s preeminent place in investor portfolios. First, multiple layers of regulations between the People’s Bank of China, the China Banking Regulatory Commission (CBRC), and the China Securities Regulatory Commission (CSRC) complicate the investment process. Second, price discovery is still an issue. In most cases, credit risk has yet to be fully priced in for both genuine corporate bonds and sub-sovereign issuers. Chinese policy makers are walking a fine line between the need to inject more credit risk in the system – indeed default rates have increased sharply since the beginning of the year for both corporates and quasi-sovereigns – while avoiding a systemic risk event if the adjustment is too abrupt. More differentiation is needed based on bottom-up credit risk research, and we do not expect an efficient and unified rating methodology in the near future. Third, the issuer base has yet to diversify. Banks remain too dominant despite the rapid growth of the onshore insurance and asset managers’ investor base. The lack of diversification hampers liquidity and price discovery, and creates tail risks such as sudden falls in bond prices. Finally, policy makers still have to clarify precisely who meets the strict criteria of an institutional investor eligible to access the onshore bond market.

Hopes of Chinese onshore market inclusion have frequently been dashed, both on the equity and fixed income sides, and we do not see how this time will be different. The headline trillion dollar inflows advertised by many institutions is still unrealistic, in our opinion. However, if and when the Yuan uncertainties are removed and China’s FX regime is clarified, China may indeed become the next big thing in local currency markets. We are, however, only at the early stages of the eastern migration!

 

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