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COMMENTARY

The hidden dragon of 2020

A change of seismic scale has gone under-noticed in a year full of twists and turns.

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A weak US dollar and a stronger-than-expected yuan are persuading an increasing number of global funds to boost their allocation to Chinese assets.

BATTLING through a turbulent year, investors have come to terms with dramatic changes in the corporate sector as well as in financial markets.

Economies have experienced in some cases almost complete cessation of activity to contain the Covid-19 spread, but this has also led to certain prevailing shifts.

For example, digital acceleration is reframing ways of working, spending and communicating, and sustainability is being foregrounded at the corporate, industry and government policy levels.

I would like to highlight another, somewhat overlooked, acceleration with the potential of becoming a seismic shift of the year: the rise of China's onshore fixed income market.

At first glance, this may seem like a narrow development relative to, say, the changes around technology adoption.

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But as we explore further, it will be clear that this is the outcome of a meaningful divergence in economic strategy across major economies globally, and the numbers involved underpin the significance of this shift.

China has in recent years progressively opened its onshore financial markets to foreign investors through Qualified Foreign Institutional Investor (QFII) schemes and the Connect programmes that facilitate trading in domestic fixed income and equity markets.

Foreign participation is rising, albeit slowly. June of this year saw further relaxation in controls allowing greater inflows.

Accelerating

The pandemic has been speeding up otherwise slow changes in the Chinese bond market. Inflows are accelerating as China successfully contains Covid-19 domestically, emerging as the only major economy forecast to have positive full-year GDP growth.

A divergence in policy responses by Washington and Beijing has also raised the appeal of Chinese onshore bonds.

The fact that the US has undertaken aggressive monetary and fiscal stimulus over recent months - and China has not - has created a number of key factors for investors to consider.

First, a weak dollar and a stronger-than-expected yuan are persuading more global funds to boost their allocation to Chinese assets.

Second, a widening yield spread of Chinese bonds over American securities of similar quality and maturity is adding to the incentive of investing in China.

Third, the relative restraint exercised by the People's Bank of China means that the Chinese bond market can function normally, offering a good way to diversify from global risks.

The Fed has signalled that rates will stay near zero through 2023, as the economy takes time to return to its previous strength.

China, on the other hand, has surprised many by resisting the temptation to flood its economy with cheap credit.

Rare haven

When global fixed income investors scrambled for cover in panic selloffs in March, China's onshore bond market offered a rare haven with low volatility and no liquidity crunch.

As capital controls are loosened and foreign inflows gradually rise, the Chinese market will become more correlated with the rest of the world.

But until a critical mass is reached, the country's diversification benefit for global investors will remain.

China's quick "first in, first out" recovery from the pandemic has set the stage for a strong rebound in economic activity. Tens of millions of people toured around China in an eight-day national holiday through Oct 8, while much of the world remained under tight travel curbs.

There is plenty of room for growth in foreign participation, as money from overseas accounts for only around 3 per cent of China's US$14 trillion onshore bond market, far below levels of 10 per cent and above for Asian neighbours like Japan and South Korea.

Chinese government bonds (CGBs) have captured most inflows to the country, while the foreign presence in the corporate segment is still negligible due to a lack of inclusion in global indexes.

But the floodgate has opened.

Global index compilers have been adding CGBs as well as bonds issued by Chinese policy banks, following the launch of cross-border trading links in recent years.

The Chinese Interbank Bond Market and the Bond Connect programmes have both widened access for foreign institutional investors.

While foreign investors still face restrictions on security types, hedging and repatriation of funds, I expect cross-border trading rules to ease further in the foreseeable future.

There is a high chance that overseas institutions will be allowed to trade CGB futures, although derivative products, which are scarce for locals as well as foreigners, will likely remain off the menu.

US-China tensions

On the geopolitical front, tensions with Washington have prompted Beijing to speed up the opening of its financial markets to global capital. Efforts to promote broader international use of the yuan should also boost inflows to Chinese onshore bonds.

Unlike digital acceleration, the rise of China's fixed income market is evolving with little fanfare. But the potentially seismic shift is firmly underway, with huge implications for the landscape of global fixed income investments.

  • The writer is chief investment officer, Asia-Pacific, Fidelity International

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