China’s Central Government Bonds (CGBs) make a compelling investment right now.
Assets denominated in renminbi (RMB) have gained a lot of traction over recent years. This year alone, Central Government Bonds (CGBs) have seen a tripling of portfolio inflows from foreign investors – inflows into CGBs in the first eight months of 2020 stand at RMB290bn, compared with only RMB89bn over the same period in 2019 1. These inflows have been driven, in part, by the inclusion of CGBs into several global bond indices over the last two years (including the Bloomberg-Barclays Global Aggregate Index and the J.P. Morgan GBI-EM Index).
But in many ways, the CGB market is still at an early stage of development—after all, outstanding CGBs are less than 20% of China’s GDP. In comparison, outstanding marketable U.S. Treasuries are approximately 100% of U.S. GDP 2. This may come as a surprise to those accustomed to seeing China’s relatively high economy-wide debt-to-GDP ratio. However, most of China’s outstanding debt has been issued by state-owned enterprises (SOEs) and local governments. Meanwhile, Central Government Bond issuance has been more modest in the past, and has only started to pick up in recent years after several policy changes that resulted in the central government taking on more borrowing responsibilities. And despite the rapid increase this year, foreigners still only own around 9% of the CGB market, compared with 30% in Indonesia, for example 3.
Looking ahead, there are three reasons why we think CGBs are a compelling investment prospect. First, COVID-19 has amplified the policy differences between the People’s Bank of China (PBoC) and the Federal Reserve. This has resulted in all-time high interest rate differentials, in China’s favor, particularly at the longer end of the curve. Second, CGBs have much lower volatility compared with other emerging market sovereign bonds. Third, a stable-to-stronger RMB will help to boost return in USD terms. Below we will look at each in turn.
First, the difference between interest rates in China and the U.S. is at an all-time high.
Throughout the 2018-2019 trade war, and in spite of weak global growth, the PBoC generally refrained from lowering interest rates and only delivered an 16bps rate cut in late 2019. During the COVID-19 pandemic, the PBoC has also adopted a relatively conservative stance, only lowering the policy rate by a total of 30bps this year. Given China’s more effective containment of COVID-19 so far, the PBoC will likely be able to maintain its policy rate. By comparison, much of the rest of the world, and in particular other emerging market economies, are likely to see further easing.
To some extent, China’s conservative approach also reflects a structurally hawkish (i.e., restrictive) policy bias of the PBoC that’s become more evident in recent years. Relative to other central banks, the PBoC has a bigger aversion towards inflation, and in recent years controlling leverage has become a higher priority. Ironically, geopolitical tensions have further reinforced this conservatism, as policymakers have focused on reducing risks rather than fueling growth. Lastly, Chinese policymakers are keen to attract inflows that can offset some of the structural outflows. As one of the last remaining major economies with rates above zero, China has become a more attractive relative destination for yield-seeking investors.
Meanwhile, the Federal Reserve has cut interest rates to zero and restarted its quantitative easing program to combat the economic fallout of COVID-19. During its annual monetary policy review at Jackson Hole, the Fed announced that it is moving to an average inflation-targeting framework, implying that it will keep policy rates lower for longer.
Overall, these developments have led to a further widening of the interest rate differential between Chinese and U.S. government bonds—to an all-time high of 230bps (Chart 1). Given China’s more conservative bias, CGB yields will likely stay stable in the near term. Therefore, we think China’s yield advantage, while it may narrow somewhat as economic conditions around the world stabilize, is likely to persist—especially versus the U.S. and also Europe (Chart 2). Over the long term, the yield on China’s sovereign bonds will likely converge with developed market levels, due to its high debt levels and declining trend growth, bringing the prospect of capital appreciation for bond holders.
Secondly, CGBs have much lower volatility compared with other emerging market sovereign bonds (in local currency terms).
As Chart 3 illustrates, CGBs have seen far lower volatility than the sovereign bonds of its emerging market peers (here we measure volatility using standard deviation of the 10-year sovereign bonds of respective governments). Chart 4 further puts this stability in context. CGBs stand out with a fairly unique combination of reasonable yield and ultra-low volatility.
Last but not least, a stable-to-strong RMB can help boost returns for investors (in USD terms).
China’s policymakers will always pay close attention to the RMB’s valuations versus a basket of currencies. Right now, valuations look reasonable across several metrics (such as the Real Effective Exchange Rate measurement by the Bank of International Settlement, and the CFETS RMB basket, which is China’s official basket). In other words, RMB vs. other currencies has not been too onerous for exporters. And over time, as the driver of China’s growth shifts more towards domestic consumption, the relationship between FX and the overall economy will also likely become more nuanced. To put it simply, while a weaker currency can help an export-oriented economy, it is less helpful for a consumption-oriented economy,as it weakens consumers’ purchasing power of imports.
What are the current risks of investing?
Mainland China still has restrictive capital controls, which means that access is not readily available for everyone and can be operationally quite complex. Fortunately, qualified investors have access to the CNH market in Hong Kong, which operates more freely. In addition, some qualified mutual funds may already have gained access to the onshore market. Another risk could come from higher yields elsewhere in the world, particularly in the U.S.—which would diminish China’s current yield advantage. However, even as inflation expectations may pick up somewhat following additional stimulus in the U.S., the overall yield trajectory in the U.S. is one of lower for longer. Thus, we expect the interest rate differential to persist. Last, while China has managed to contain the pandemic while allowing growth to recover, COVID-related uncertainty nonetheless lingers.
Putting it all together
The combination of a compelling yield advantage (particularly longer-dated bonds), low volatility, and a stable currency makes a compelling case for CGBs as an investment opportunity. Investors have several options to gain exposure, namely through the CNH-denominated CGB market in Hong Kong and through mutual funds, which can invest in a combination of sovereign and investment grade credit with varying levels of currency exposure or overlay.
1. China Central Depository & Clearing, August 2020
2. Wind and Haver data, July 2020
3. Asian Development Bank, data as of 2020
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