Alicia Garcia Herrero, Natixis Asia Pacific Chief Economist, Bruegel Senior Fellow
Given the scorching growth of China’s bond market, that sped faster than its economy, over the recent years, it is not surprising that the year 2020 saw increasing foreign investors’ interest. While Covid ravaged economies the world over, overseas investors poured money into China’s bonds attracted, among others, by the compelling yield differential, and seemingly unperturbed by the increasing credit risk.
Foreign holdings of Chinese onshore bonds, for instance, accelerated from 2.96% in September 2020 to 3.2% in December 2020, the bulk of which was accounted for by Chinese fixed income bonds, which are either government or quasi-government papers.
And, although small as a percentage share, the increasing foreign investor interest is also a testimony to the success in China’s pursuit to attract foreign capital despite the challenging geopolitical environment.
Going forward however, it is vital for China to sustain this interest into bonds- including those issue local governments, corporates and banks- not only to maintain the momentum of inflows. But also to lower the high credit spreads between government and corporate bonds , especially for privately-owned enterprises. In 2020, strong net issuances were driven by banks and other financial institutions on the back of strong liquidity and capital needs. A similar growth was driven by local governments and their financial vehicles, reflecting their role in boosting infrastructure within China’s stimulus package.
Plans to simplify processes for foreign bond investors and the opening up of new investment channels — such as the bond connect scheme — made things easier for overseas investors as well. Likewise, the inclusion of Chinese bonds into global indexes (managed by Bloomberg, JPMorgan Chase, and FTSE Russell) had also helped to attract capital inflows. Regulation too, specifically for corporate bonds, had been strengthened over the past few years.
China’s bond market also offered investors the option of diversification. With assets more closely linked to domestic conditions, and low foreign participation relative to its economic size, there is also still room for active foreign inflows to continue.
High default rate
Yet China’s bond universe is facing structural challenges. In the face of the global pandemic, while economic growth in the country is rebounding, repayment pressure for corporates has worsened and bond defaults have increased sharply, although still from a very low level.
And this trend is different from the past for two reasons. This time around, state-owned enterprises (SOEs) have become a major source of bond defaults. Second, a few highly rated SOEs have experienced difficulties in repayment since 2019.
The US-China trade war since 2018 as well as the shock from coronavirus in 2020 have also clearly contributed to the deterioration. Furthermore, the fiscal situation of local governments has also worsened in the past few years and has further exacerbated with the Covid shock. In other words, the debt and fiscal deficits of local governments seem to come hand in hand with more bond defaults.
While general sentiment for both onshore and offshore bonds has continued to improve, the renewed concern on defaults stands firm, and is likely to remain an issue in 2021 — although concentrated to specific names and sectors.
Couple this with a slowing of onshore issuance, and the recent rebound in US Treasury Yields since December 2020, foreign investors may start to find the Chinese bond market less appealing in the course of 2021. If we also add the fact that the RMB has appreciated quite rapidly against the dollar in 2020, the room for further appreciation might no longer be there.
Overall, the reduction in the tempting interest rate differential which has been pushing inflows into China’s bond market, and the increasing credit risk do not augur well for foreign investors to continue to rush into the Chinese market. Finally, while diversification reasons are still valid, the new sanctions on an increasingly large number of Chinese names will certainly not help in 2021.
* This article was originally published by Asia Times Financial on 30th Jan: