Non-Chinese investors are shifting into yuan-denominated government debt at a record rate as they seek a safe haven amid the coronavirus pandemic. The shift bears signs of longer-term recalibration of global finance.
When the Financial Times claimed China's $13 trillion (€11.7 trillion) onshore bond market had become "an unlikely sanctuary," some eye brows were raised. Given the timing and scale of the COVID-19 impact on China's economy, few expected it.
But become one it has. As of the end of March, some 822 non-Chinese investors held 2.26 trillion yuan ($319 billion, €280 billion) in Chinese central government debt, down from the record 2.28 trillion yuan at the end of February, but up a whopping 28% in the first quarter year-on-year.
Foreign investors remain a small percentage of the $13 trillion market, at 2.3%, compared with the United States' 28%, much of it Chinese-owned, but this is changing.
While China's GDP fell 6.8% in the first quarter , the IMF is forecasting a recovery to 1.2% growth for all 2020, unlike most global economies, in positive territory. Exports, which make up 18% of GDP, are expected to fall by up to half in the first quarter, and industrial profits by 25% in the first half after retail sales and investment in fixed assets fell 20% in Q1. But while Beijing has yet to sign off on a fiscal boost program, it is only a matter of time, observers say, with central bank purchases of bonds one of the likely options.
Diamonds are forever: Yield gap widens
Uncertainty caused by the spread of the coronavirus and the ongoing US-China trade spat has driven investors to shift assets into the largest and most liquid bond markets: US Treasuries, German bonds and Japanese government bonds. "World sentiment toward China is improving due to its early containment of the coronavirus outbreak, and this is making Chinese bonds look like a shelter in the global storm," said BNP's Chi Lo.
But monetary policymakers also pushed interest rates to new lows, with negative rates in Japan and parts of Europe, sending bond yields down. The yield on the 10-year US Treasury, for example, has dropped by 95 basis points since mid-February. Risk aversion in the market drove down the yield of US 10-year Treasury bonds to less than 1% from over 1.8% at the start of 2020. The yield on Germany's 10-year government bonds fell deeper into negative territory at -0.6%, down from -0.2% earlier this year.
Despite dropping to a record low of 2.47%, Chinese 10-year government bonds continue to have an advantage over their rivals. The yield of China's 10-year government bonds traded between 2.8-3% during the first quarter of 2020 and is widely seen increasing to 3.3% by the end of 2020, according to MRB Partners. The yield spread between Chinese 10-year government bonds and US 10-year Treasury bonds rose to 175 basis points, up from around 42 basis points a year ago.
"China bonds appear attractive to foreign investors given the yield pickup China offers versus developed market sovereigns," said Lucy Qiu, emerging markets strategist at UBS Global Wealth Management in a recent interview with Xinhua.
For your eyes only: Sentiment changing
Investors are also turning positive on China's economy, with Morgan Stanley raising its overweight position on China's equity markets. The government is expected to undertake additional fiscal stimulus to boost the economy, which could fare better than other major economies around the world this year, according to investment manager Invesco.
"China is likely the only major economy that will squeak out positive GDP growth for 2020," David Chao, global market strategist for Asia-Pacific excluding Japan, at Invesco, said. "Whether that will be 1% or 3% is very much dependent on the government's policy — specifically any additional fiscal stimulus packages that will drive growth in the second half."
Some believe the coronavirus pandemic could signal the end of the dollar's reign as the global reserve currency
The increase in foreign inflows into the Chinese bond market since mid-2017 has also been in part due to the inclusion of Chinese bonds on major benchmark indices and in particular after the launch in 2017 of the Bond Connect program, which allows foreign investors to trade in mainland China's bond markets through Hong Kong without an onshore trading entity.
"The opening up of onshore interbank bond market to international investors in recent years, notably with the China Interbank Bond Market Direct in 2016 and Bond Connect in 2017, enabled them to increase their exposures in RMB-denominated assets," Jessie Tung, VP-Sr Credit Officer at Moody's Investors Service, said.
"Chinese securities are becoming an asset class of rising importance and ease of trading has allowed investors to capture investment windows in the most timely manner," said Julien Martin, general manager at Bond Connect.
Last April, Bloomberg began phasing in yuan-denominated government bonds to its $54 trillion Bloomberg Barclays Global Aggregate Index over a 20-month period. Since then, $69 billion in foreign money has moved into Chinese domestic bond markets.
Hayden Briscoe, head of fixed income for Asia-Pacific at UBS Asset Management, said the inclusion of Chinese debt represents the "single- largest change in capital markets in anybody's lifetime.” Central banks, sovereign wealth funds and index trackers could potentially represent $3 trillion in inflows, he said.
One of the new channels to emerge is Bond Connect. Bond Connect has been a game changer. This new channel of access has allowed many investors to access China's bond market without having to set up accounts domestically," said Jinny Yan, the London-based chief China economist at ICBC Standard Bank.
Live and let die: The end of US hegemony?
Some believe the pandemic could signal the end of the dollar's reign as the global reserve currency. China had already been moving away from reliance on the US dollar and has been adding to its gold reserves, a process known as dedollarization.
"Major movers, such as China, Russia and the EU have a strong motivation to dedollarize," Anne Korin from the Institute for the Analysis of Global Security told CNBC.
"We don't know what's going to come next, but what we do know is that the current situation is unsustainable," she added. China has tried to internationalize the use of its currency, including the introduction of yuan-denominated crude oil futures, also referred to as "petro yuan," which could "serve as an early warning sign for the dollar's waning dominance," Korin noted.
China and US need each other
China has reduced its holdings of US debt since 2011, when it held $1.3 trillion, and in taking steps to transition the yuan to a global currency has loosened its peg to the dollar. But as the yuan appreciates, China's exports decline and Beijing becomes less able to invest in US Treasuries, thus reducing access to cheap credit for American consumers, who buy Chinese products.
Meanwhile, China's demand for US Treasuries helps keep US interest rates low and enables the US Treasury to borrow at low rates. China's position as America's largest banker gives it some political leverage, but Beijing knows that if it were to cash in its US debt all at once, demand for the dollar would plummet, disrupting international markets and hitting China's economy, too.