Chinese bond markets – a policy shift
The change in foreign exchange policy by the People’s Bank of China (PBOC) took global markets by surprise. The resulting depreciation of the renminbi by 3-4% led to similar moves across most Asian currencies. Further away, US Treasury bonds rallied as the currency moves reinforced the marginally negative effect that a stronger US dollar will have on the American economy. But apart from these immediate repercussions on the rest of the world, little attention has been given to the longer term effects the policy shift is likely to have on China itself and its bond markets in particular.
The policy shift will likely have little impact on foreign currency (mostly US dollar) debt markets. Traditionally, sharp currency depreciations can have dramatic effects on emerging markets that experienced large and rapid build-ups of external debt in foreign currency. Rising leverage leads to balance sheet stress, loss of foreign exchange reserves and difficulties in meeting larger debt service requirements. This is not an issue in China. While Chinese corporates have been the largest issuers of foreign currency bonds over the past five years, taking the total amount of bonds outstanding from 50bn USD in 2010 to 450bn USD in the first quarter of 2015, it remains small compared to the size of the Chinese economy (4% of GDP) or compared to the PBOC’s foreign exchange reserves (12%). Moreover, recent depreciation of the renminbi has been very small. Even if the Chinese currency were to keep depreciating by 10 to 20%, it is estimated that most Chinese corporates, even those that have the largest share of foreign currency denominated debt, can manage such move thanks to dollar revenues and dollar assets. The most leveraged sectors in foreign currency also generally benefit from good liquidity and margins. Banks do not have unhedged foreign currency exposure.
Recent changes in FX policy by the PBOC could actually be supportive for China’s USD bond markets. More two-way volatility and uncertainty over the direction of the exchange rate, in addition to the expected increase in US interest rates, will make foreign funding less attractive for Chinese firms. Less issuance of USD paper, coupled with still strong appetite from local investors for foreign currency assets, paints a positive technical picture for the asset class. However, there remains a large differentiation across companies’ fundamentals and individual credit analysis is key for investors in Chinese bond markets.
The move towards more exchange rate flexibility is an important step for the Chinese domestic bond markets. With over 4 trillion dollar equivalent in renminbi-denominated bonds, it has grown to be one of the largest bond markets in the world. But despite that fact, because it is still subject to controls for access by foreign investors, it tends not be included in global bond benchmarks. In that respect, the change in policy is important on several grounds. First it signals the continuation of gradual financial reforms, which makes it more likely that in future Chinese domestic bonds might be included in global indices. Second, it answers one of the points the IMF cited as holding back the inclusion of the renminbi into its Special Drawing Rights (SDR) basket. Inclusion in the SDR basket would encourage central bank reserve managers to hold renminbi in their core portfolio. And third, if renminbi depreciation continues, it will correct the perceived overvaluation of the currency, which was often estimated at around 10% before the change in policy. A currency nearer fair value and expectations of monetary policy easing in response to a slowing economy would make the Chinese domestic bond market relatively more attractive to foreign investors.
Nicolas Jaquier , Emerging Markets Economist, Standard Life Investments
First published in Institutional Investor China in September 2015