China’s Bonds Get a $2.5 Trillion Test Run

(Bloomberg Opinion) -- By next spring, Chinese government and policy bank bonds denominated in renminbi could be part of the Bloomberg-Barclays Global Aggregate, the debt-market index with the largest amount of assets under management. Global Agg, as it’s known to traders, represents about $2.5 trillion worth of securities. Macro investors should take notice of Beijing’s move, for at least two reasons.

First, this would mark another milestone in China’s gradual liberalization of its capital account (the money flows in and out of the country). If sustained, this process would herald a big shift in long-term capital allocations around the world. China would be expected to take fourth place in the Global Agg after the U.S., the euro zone and Japan, with a projected index weighting of 5.5 percent. Second, Chinese yields might exert greater influence over the pricing of global long-term interest rates and, in turn, become more sensitive to movements in bond yields abroad.

Like most things to do with China, even the local bond market is remarkable for its size. At $12 trillion, it’s already the world’s third-largest by capitalization, and it’s projected to double in the next four years to about $24 trillion, according to Goldman Sachs estimates. The share of the market that’s narrowly defined as Chinese Government Bonds (CGBs) is in the ballpark of $2 trillion and, on Goldman’s numbers, is forecast to reach $4 trillion by the end of 2022. By comparison, Germany and France combined have $2 trillion of central government bonds outstanding, outside those sitting on the ECB’s balance sheet.

Yet the Chinese bond market has been grossly under-represented in global fixed-income portfolios. Overseas investors hold a meager 2.1 percent of the stock of Chinese bonds outstanding and just 7.5 percent of CGBs. This doesn’t reflect the country’s place in the global economy. Indeed, China represents 22 percent of global GDP (at purchasing power parity), 5 percent more than the U.S., and is the biggest trading nation in the world. For many emerging market countries, especially those in Asia and the commodities exporters, China is their biggest trading partner and, increasingly, a key lender.

Ahead of any index inclusion, inflows into China’s bond markets have picked up rapidly. Foreign net purchases of CGBs hit $70 billion in the nine months to October, nearly four times the pace of the past two years. The stock of government bonds held by foreigners reached $155 billion at the end of October. Purchases of Chinese bonds appear to have originated mostly from long-term capital pools such as currency reserve managers, pensions and sovereign wealth funds. Over this same period, foreign holdings of U.S. Treasuries were stable at about $6.3 trillion — roughly half the amount of those outstanding, excluding those held by the U.S. Federal Reserve. Most emerging markets have been facing outflows.

Though likely, entry into the Global Agg isn’t a done deal. The Chinese authorities still need to fix some important technical issues to make sure the market is functioning adequately. Amid investors’ concerns about issues such as the rule of law, the index’s advisory council could delay the country’s entry if it doesn’t put in place the needed changes. At 20 months, the entry phase for inclusion is also much longer than the norm.

But should China be accepted, more private capital inflows may follow, especially if people take it as a signal that an entry into the JP Morgan and Citi global bond indices might follow. Goldman Sachs researchers estimate that overseas holdings of Chinese securities will quadruple over the next four or five years.

As investors make room for China’s possible entry into the indices, any portfolio adjustments will come at the expense of other emerging markets such as Indonesia, Thailand and Malaysia. This doesn’t mean necessarily that their bond markets will under-perform. Local and international macroeconomic factors usually matter more than investor flows in driving returns. Also, over the longer term, the bulk of the capital allocation shift toward China would be out of the dollar. So foreign demand for U.S. Treasuries may remain stagnant.

The most important consequence of China’s integration in the international financial system, however, will ultimately be in prices. Across most of the world, and certainly in emerging economies, the U.S. is a key determinant of local asset prices. Depending on the pace of China’s capital account liberalization, that assumption may have to be revisited.

Until recently, the evidence has suggested that changes in renminbi swap and bond yields had only modest effects on regional bond markets compared with those of U.S. rates. During the past year, however, intermediate maturity rates in Australia and South Korea have taken their cue more from yields in China than those on U.S. Treasuries.

Although it’s premature to conclude that international yield correlations have shifted structurally, that change in pricing patterns merits attention. An increase in foreign participation in China’s bond markets will also mean that its own yields are a bit more subject to foreign pressures. Even as Chinese yields have more of an impact abroad, it will also be less easy for the country’s bonds to “bowl alone.”

To contact the editor responsible for this story: James Boxell at jboxell@bloomberg.net

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Francesco Garzarelli is a former partner at Goldman Sachs International, specializing in global macro and markets.

©2018 Bloomberg L.P.