Understanding reserve investment in China
An outlook on China’s economy, rates and currency and the increasing attractiveness of Chinese bonds.
From the source: reserve management in China
Following years of rapid growth, China’s onshore bond market is now the second largest in the world.
Amid expectations for further expansion, the market is capturing the attention of global central bank reserve managers thanks to the attractive yields, stable currency, and the potential for portfolio diversification and enhanced risk management.
Despite its rapid evolution, foreign participation in China’s onshore bond market remains small in terms of the market’s overall size. Foreign inflows are expected to climb to a record CNY1.5 trillion (USD230 billion) this year, as the economy recovers strongly from the COVID-19 pandemic and market-friendly reforms are introduced.
The growing opportunity for foreign central bank reserve managers, alongside the evolving regulatory framework, was the focus of discussion for high-profile speakers at Standard Chartered’s Central Bank Symposium that attracted attendees from more than 70 global central banks and investors last week.
“The momentum is still very much there, and it will continue,” Eddie Yue, Chief Executive of the Hong Kong Monetary Authority (HKMA) told the symposium. “It’s a young journey and we have a long way to go. In 10 years’ time, the market will be much bigger than now, foreign participation will be much wider, and I hope the range of products will be broader and the supporting infrastructure will be greater.”
Powerful growth
Interest in China and its domestic capital markets has gathered pace alongside the country’s emergence as a core engine of the global economy.
The inclusion of China in global bond indices and other key market benchmarks added to the momentum and, in the past decade, the Government has taken key steps to open its domestic capital markets and to liberalise its currency regime. These measures underscored a dramatic increase in foreign investor interest from around the globe.
Alongside this, many nations are still grappling with the fallout from the COVID-19 pandemic, while China and other parts of Asia offer powerful growth stories and an opportunity for investors to diversify.
“The importance of diversification in fixed-income portfolios is growing all the time,” said Eric Robertsen, Global Head of Research and Chief Strategist at Standard Chartered. “In the past year we’ve seen most of the developed world bond markets behaving in a highly correlated fashion, but China’s bond market was uncorrelated to that.”
Attractive yield
China’s bond market offers high-quality instruments with a good risk-return balance, according to Mr. Yue, who noted that China’s government bonds offer an attractive yield pickup over comparable US Government bonds.
While the onshore legal processes, regulations and compliance procedures can be complex, investment channels like Bond Connect, which offers overseas investors access to fixed income markets in Mainland China via trading infrastructure in Hong Kong, are ways to bypass those challenges, Mr. Yue said.
“You really have to understand the market, the rules and the regulations, and you have to know people who follow the market,” Mr. Yue said. “Some of the rules and regulations may seem minor but can have a big impact on your operations and holdings. You really have to follow the developments.”
Parts of the infrastructure still have some way to evolve − for example those that allow hedging − as does the risk management side, Mr. Yue said. The range of products on offer is also fairly limited, even as sophisticated instruments start to develop. Reliable credit ratings are a key plank required by the investor community.
Regulatory improvements
A lack of clarity about investment rules and sometimes complicated operational processes are the main barriers to investment, cited by 45 per cent of attendees at the symposium, followed by the ability to hedge effectively and a lack of liquidity.
“We are at the beginning of a long journey of global asset allocation into China onshore bonds,” said Becky Liu, Head of China Macro Strategy at Standard Chartered. “Foreign private sector investors have recently surpassed public sector investors as the main source of foreign inflows in recent quarters.”
Liquidity was a key concern for the HKMA when it began investing a decade ago, Mr. Yue said, but things have improved markedly since.
China’s market also has some way to go to adapt to the growing trend for Environmental, Social, and Corporate Governance (ESG) investing, he said, with the supply of “green bonds” – those that fund projects with positive environmental and climate benefits – quite scarce.
Strong economy
The symposium also discussed the outlook for China’s economy, with leading indicators suggesting momentum and a pick-up in activity in the second quarter. The economy grew by 18 per cent in the first three months of the year compared with the same period last year.
Standard Chartered predicts good growth and a stable monetary policy outlook for China, as well as low market volatility and a positive outlook for the currency, Mr. Robertsen said. As the country emerges from the COVID-19 pandemic ahead of its peers, the economy will strengthen further.
Against that backdrop, participation in China’s capital markets is set to grow as its GDP matches and then surpasses that of the US in the next decade, underscoring its importance to the world economy.
“Interest in China and its domestic capital markets is as strong as ever,” said Karby Leggett, Global Head, Public Sector and Development Organisations, Standard Chartered. “We’ve just scratched the surface of this opportunity.”