Unveiling What’s Next for China’s Bond Market
Transcript of Unveiling What’s Next for China’s Bond Market
Will the FTSE Russell Index inclusion and improvements in renminbi execution boost foreign inflows?
Unveiling What’s Next for China’s Bond Market
Shen Li Head of Global Markets China & Head of Indirect FX
and Street FX, Asia Pacific, State Street
Foreign holdings of China’s bonds ended 2020 at ¥3.25 trillion, having increased by a record ¥1.15 trillion during the year.1 The inclusion of China’s sovereign bonds in the Financial Times Stock Exchange (FTSE) Russell World Government Bond Index (WGBI), to be rolled out from October, should add fresh impetus to foreign inflows.
1 https://www.chinabond.com.cn/cb/cn/yjfx/zzfx/yb/20210107/156271799.shtml
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This inclusion is a major step toward
full representation in the global bond
market. It is likely to justify additional
allocations from foreign money
managers and asset owners with
roughly US$2.5 trillion in assets under
management that follow the WGBI.
However, FTSE Russell’s decision to build up to
the total weighting of 5.25 percent over a period
of three years rather than one year, as originally
intended, signals that the index provider – and
the investors it consulted with – still have
some reservations about the regulatory and
operational effectiveness of the market.
Fresh Impetus For Foreign Ownership?
FTSE Russell is now the third global index
provider to incorporate Chinese government
bonds. The Bloomberg Barclays Global
Aggregate Index was the first to incorporate
onshore Chinese yuan renminbi (CNY) bonds
in April 2019 and took 20 months to build up to
a 7 percent weighting. The JPMorgan Government
Bond Index-Emerging Markets (GBI-EM) inclusion
followed in February 2020, with a 10-month
timeframe to reach China’s 10 percent weighting.
These forerunners have been a factor in the
continued rise in foreign ownership of Chinese
government bonds since 2019 (see Figure 1).
Though at around 10 percent at year-end
2020,2 foreign ownership is still only about
a third of the 30 percent foreign holdings of
United States Treasuries.
2 https://content.ftserussell.com/sites/default/files/ftse_russell_china_bond_report_mar_2021_final.pdf
Figure 1: Foreign holdings of Chinese bonds (December 2017 – December 2020) (AANA)
2000
1600
1200
800
400
0
3.5
3.0
2.5
2.0
1.5
1.0
China Government Bonds China Policy Bank Bonds NCDs All (RHS)
12/2017 6/2018 12/2018 6/2019 12/2019 6/2020 12/2020
CNY Billions CNY Trillions
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With primarily passive investors following
the benchmark, the FTSE Russell inclusion
may change this trend and it is likely to steadily
increase their weighting of China’s bonds to the
required level. For example, Japan’s institutional
investors are known to follow WGBI, including
the likes of life insurers and large pension funds.
If passive investors simply follow the
recommended weighting, it implies a total inflow
of around US$150 billion. Also, if central banks
increase their reserve holdings to reflect the
yuan’s 10.9 percent weighting in Special Drawing
Rights (SDR), it would add a further inflow of
US$311 billion.3 A report from the Institute of
International Finance predicts that should global
yuan reserves reach 3 percent of China’s gross
domestic product (GDP) over the next 10 years,
it would imply annual inflow of more than
US$400 billion.4
China also has fundamentals in its favour, with
most of the world’s major economies still mired
in zero interest rates and negative short-term
government bond yields. China’s 10-year yield
is almost double that of US Treasuries and still
offers an attractive premium even after foreign
exchange (FX) hedging costs are stripped out.
Combined with the relatively shorter duration
of its market indexes, China’s sovereign credit
rating of A+ is in clear contrast with G7 bonds,
which helps improve the risk-reward ratio
that is paramount to institutional investors.
To date, China’s bond market has shown a low
correlation to global fixed-income markets,
adding another benefit of diversity to an already
attractive market.
Addressing Market Obstacles
Difficulties with FX hedging have continued to be
a significant drawback for investors as it has an
important bearing on the net yield. These issues
ranged from operational, with the separate on
and offshore currencies having the same
International Organization for Standardization
(ISO) currency code, to executional, with a lack
of pricing counterparties and transparency.
To help resolve the issue, the Hong Kong
Monetary Authority enhanced the flexibility
of yuan transactions in March 2021 by allowing
asset managers of up to three banks to conduct
competitive FX pricing. The greater liquidity and
transparency from the ability to compare prices
brings the yuan up to a global standard and is an
important improvement for foreign institutional
investors that have to show provable best
execution for trades.
The greater liquidity and transparency from the ability to compare prices brings the yuan up to a global standard and is an important improvement for foreign institutional investors that have to show provable best execution for trades.
3 https://www.ftserussell.com/blogs/chinas-wgbi-entry-will-confirm-its-arrival-global-market4 https://www.scmp.com/economy/china-economy/article/3141932/chinas-yuan-bond-market-could-attract- us400-billion-year-over
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Banks that have China foreign exchange trade
system (CFETS) overseas bank membership and
FX Settlement Bank status will be best positioned
to offer ample yuan liquidity in spot, forward and
swap markets that clients need for their trading
and hedging requirements.
However, investors are still only allowed to
conduct currency and hedging transactions
as long as they are supported by genuine and
reasonable bond transactions, with a tolerance
of 15 percent.5 This restriction – aimed at curbing
speculative activity – may still prove a hurdle for
those active managers that want to make short-
term profits from a bond issue by oversubscribing
for their desired amount, and therefore, need
excess cash in advance. Whereas for more
cost-conscious passive funds, competitive pricing
removes their biggest impediment.
5 https://www.hkma.gov.hk/media/eng/doc/key-information/guidelines-and-circular/2021/20210305e1a1.pdf
Figure 2: How State Street is helping clients to navigate market challenges
• Liquidity challenges for
FX hedging
• State Street has CFETS overseas
participant bank membership
and FX Settlement Bank status
• Offers 3rd party CNY FX
for funds custodied elsewhere.
This enables clients to settle
and hedge all their managed
portfolios.
• With an increased pool of
liquidity, investors are able
to more closely meet their
fiduciary obligations to help
achieve best execution and
see more competitive pricing
• Operational inefficiencies
and price opaqueness around
FX hedging
• Offers clients CNY liquidity in
spot, forward and swaps from
the deep CFETS liquidity pool;
and both CNH and CNY securities
and FX denominated services for
individual funds concurrently
• Capability to distinguish
between CNY and CNH assists
investors with selecting a more
economical funding currency -
hedging is often cheaper in CNY
than CNH especially in times of
increased volatility.
• Administrative challenge created
by CNY and CNH having the same
ISO currency code
• State Street’s automated
solution uses a segregated
securities account for each
funding channel, and uses the
securities account number as
a unique identifier for tracking
funding and hedging currency
• Helping to significantly reduce
the administrative burden on
investors seeking to hedge in
the CNY and CNH markets
Challenge to market participation
State Street solution/support
Outcome for clients
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International Bond Indices Send
a Clear Message to Global Investors
International bond indices are sending
a clear message to investors worldwide that
they believe China is ready to become a full-
fledged member of the world’s sovereign bond
community. Yet global fund managers have
remained circumspect, even as government
reforms steadily lower operational hurdles and
open up China’s bond market to foreign players.
The arrival of the FTSE Russell Index, combined
with a significant step forward in FX execution
and competitiveness, may finally be the invitation
the rest of the world accepts.
2021The Hong Kong Monetary Authority enhanced the flexibility of Yuan transactions by allowing asset managers up to three banks to conduct competitive FX pricing.
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For more information, please contact:
Shen Li
Head of Global Markets China & Head of Indirect FX
and Street FX, Asia Pacific, State Street
+852 3667 7019