Funds Europe – FTSE Russell is set to add Chinese bonds to the World Government Bond Index over a period of three years. What impact do you expect this inclusion to have on foreign holdings of Chinese government bonds, which have traditionally been low, as well as on the wider Chinese bond market?
Zhang – The global standard is whether it makes sense to put an investment on a risk-adjusted basis, so it’s a good thing that Chinese bonds are being added to the index. It opens the door significantly to passive investors. But the key question is whether it’s worthwhile to put money to work in Chinese government bonds.
Comparing US and Chinese ten-year yields, the US yield is 1.45% and the Chinese yield is twice as much at 2.9%. If you look at the duration, the US aggregate duration is about 6.9 to seven years, and the China aggregate is offering five years. So, the yield is more attractive for Chinese government securities and the duration is shorter as well.
In terms of credit rating, the US is AA or AAA, China is A1 or A+ depending on the agency, but the reality is China is pretty safe. The government bond is offering you liquidity and security. Also, the renminbi itself is stable, and in the foreseeable future I think the appreciation possibility is maybe higher than for depreciation. So, all these tailwinds are, in our opinion, helping Chinese government bonds be more attractive. It makes a lot of sense for investors to come in, whether they are passive or active.
Yin – Index inclusion is a key milestone in China’s capital-account liberalisation process. It really sends a strong signal to the world that Chinese capital markets are now on the global stage. The most direct impact of index inclusion is of course the increased passive investment that tracks those indices – but more importantly, compared to trillions of dollars tracking these indices explicitly, considerably more assets used them as a reference for allocation in asset-owner communities.
History shows that index inclusion can be a major catalyst for significantly increased foreign holdings of domestic assets. I’m using equity as an example here, but I think the effect on the bond market should be rather similar. Foreign ownership of Korean equities in the late 1970s was around 1.5% of market cap and the share for Taiwan was also low. Five years after index inclusion, foreigners owned about 10% of Korean and Taiwanese equities by market cap. So, the longer-term potential is certainly there, but the shorter-term market impact is harder to predict.
FTSE is following Bloomberg and JP Morgan in the index inclusion. The allocations as a result of those changes have not had a large effect on the relative value of Chinese government bonds yet, so it’s unlikely that FTSE will in the short term.
Li – I think China’s entry into global bond indices is a key milestone for China’s financial market liberalisation process, which gives additional impetus to the broader renminbi internationalisation. When fully included in the World Government Bond Index, China’s weighting will be around 5.6%, representing the sixth-largest market in the index, even larger than the weighting of the UK. The process should accelerate and continue at a robust pace as there are several supporting factors for Chinese government bonds, such as wide rating differentiations, positive foreign-exchange outlook and diversification benefits.
Foreign flows are likely to skew heavily towards China government bonds over other onshore bonds. Foreign holdings of Chinese government bonds exceeded 2.1 trillion renminbi by mid-2021, which accounted for more than 10% of total outstanding Chinese government bonds. Comparing this to the ownership in other Asian markets like Korea in which the figure is around 18%-19%, suggests there would be sufficient room for growth.
Chinese government bonds also have proven to be an effective diversifier for global investors. Global index inclusion will further advance the development of the Chinese bond market in several dimensions.
The first is the broadened investment base which improves credit differentiation and reduces volatility in onshore credit market.
The second is the enhanced market liquidity through more active trading turnover that boosts Chinese government bond futures or repo market, and it also satisfies global investors’ hedging demands.
Once foreign investors build positions in the government bond market, the investments will further move towards the policy bank bonds and, ultimately, credit bonds. That is our view.