We see three recent developments as supportive of China’s growth and its interest-rate premium over other major economies, which may lift the RMB and related assets in 2021.
China’s “first in, first out” and subsequent effective containment of the COVID-19 pandemic has allowed its economy to recover ahead of other major economies in 2020. Part of the growth recovery was helped by exports. China’s share of global trade has surged in 2020, as the economy has stepped up to meet a lot of the world’s urgent needs for medical supplies and stay-at-home electronics equipment.
Not all of these export gains will necessarily persist when we transition into a post-COVID world. But there are fresh tailwinds too. The biggest tailwind will be the global recovery, which we believe will strengthen in 2021. The recent signing of the Regional Comprehensive Economic Partnership (RCEP) intra-Asia trade deal and Joe Biden’s victory at the US presidential election are additional supporting factors for regional trade. These tailwinds will help China’s exports to stay resilient in 2021.
Beside exports, household consumption is also expected to stage a fuller recovery in 2021. This should allow China to maintain its economic growth as well as interest-rate premium over other major economies in 2021, even as macro policies will increasingly dial back to a more neutral stance. These factors will in turn support the renminbi (RMB), especially versus the US dollar (USD), which we believe will remain in a mild downtrend in 2021. They will also support RMB assets. We particularly like Chinese central government bonds (CGBs) given its more attractive yield amongst major economies as well as lower volatility and low correlation with government bonds from other countries. Stable RMB with an appreciation bias against the USD is an additional supporting factor.
Exports outperformance helped with growth recovery in 2020
China has long been the world’s largest exporter. But during the COVID-19 pandemic and amidst the global trade slump, China’s export market share has surged even higher. By our estimates, China’s share of global exports rose to as high as 20% in Q2. Even though the share has since then come down to around 18%, but this is still higher than an average of 15-16% in 2019 (see chart 1). (Read our previous report.)
Why the jump? As global trade slowed dramatically amid COVID-induced shutdowns, China has benefited from earlier and more effective containment of COVID-19 within its borders. As a result, its economy has been able to normalize production earlier, and China’s trade surplus rebounded to a recent year high. This export outperformance has helped China’s economy recover faster, and allowing China to engage in less policy stimulus than seen in other major economies.
More tailwinds in 2021
As vaccine development races ahead, the world economy is increasingly able to look beyond the pandemic. Will China’s export resilience last into 2021?
For sure, many of the COVID-related demand, like medical equipment and stay-at-home tech will slow into 2021. But in our view there are fresh tailwinds supporting exports as well. The most important tailwind is the global economic recovery, which we believe will strengthen further in 2021.
There are two additional supporting factors for regional trade as well. First, the recent signing of the Regional Comprehensive Economic Partnership (RCEP) trade deal. This covers approximately a third of China’s overall trade. Once in force, it will help to meaningfully lower barriers in terms of intra-regional trade (particularly supply chain products) and boost regional trade growth in the coming years. Second, Joe Biden’s victory at the US presidential election is expected to lower geopolitical tail risks in the region. Against the macro backdrop of a recovering global economy, we will likely see a rebound in global and regional trade in 2021. This will help China’s exports and growth trajectory to stay resilient.
Equally important is the continued recovery in domestic demand, which is also expected to strengthen in the months ahead. We expect the labor market to largely recover to pre-COVID levels by mid-2021, allowing household income growth to largely normalize. This will in turn enable a fuller recovery in domestic household consumption. A safe and widely-available vaccine can further strengthen this process.
Resilient exports and a fuller recovery of domestic demand will help support China’s growth in 2021, sustaining its economic growth premium over other major economies. This will allow the People’s Bank of China (PBoC) to maintain its policy rate in the coming year. By comparison, much of the rest of the world, and in particular other emerging market economies, are likely to see further easing. As such, the sizable interest-rate differential between China and other major economies will likely be mostly sustained, in our view.
What it means for investment
China’s growth resilience is likely to support the RMB versus a basket of currencies, and more so vis-à-vis the USD, which we believe will remain on a mild downward trend in 2021. A stable-to-strong RMB can help boost returns for investors (in USD terms) (see chart 2).
On a related point, another asset class that will likely benefit from China’s economic growth and interest-rate premium versus other major economies is core bonds. In particular, we like China’s central government bonds (CGB).
During COVID-19, China has largely maintained a relatively neutral policy stance, with only modest cuts to interest rates and loosening of overall credit growth. Meanwhile, across developed markets, central banks have engaged in extraordinary amount of easing. And while China looks sets to dial back this modest easing bias in the coming months, most developed markets are expected to maintain or even further extend easing measures in 2021. For example, during its recent annual monetary policy review, the U.S. Federal Reserve 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 that it hit an all-time high in recent months (see chart 3). Given China’s more conservative bias, CGB yields will likely stay stable in the coming year. 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.
What are the risks?
One risk to our view would be a global growth slowdown that is material enough to dent the global recovery. This may also slow down China’s growth recovery. A sharp global slowdown could also lend some risk-off support to the USD for a period of time. But over time, slower growth will likely lead to more policy easing from central banks, particularly in developed markets. The PBoC is likely going to be one of the most conservative in terms of their policy response. As such the interest-rate differential will likely be maintained.
Conversely, another risk could also come from faster-than-expected growth recovery in the rest of the world. In particular, there may be two concerns. Firstly, would global recovery make the PBoC more wary of RMB appreciation due to its impact on competitiveness? We think the concerns are not as big as the RMB’s strength so far is primarily based on the USD’s broad weakening cycle, which is a multi-year trend in our view. In this environment, while the RMB may not meaningfully outperform its trade-weighted basket, it should nonetheless maintain an appreciation bias versus the USD.
Secondly, would we see higher yields elsewhere in the world – particularly in the U.S.—which would diminish China’s current yield advantage? We think there’s a likelihood the gap could narrow somewhat, but not meaningfully. Moreover, 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.
The aforementioned large and growing trade imbalances may result in increased political pressure. By and large, we expect that under the Biden administration, U.S.-China relations should return to a more normal and multilateral framework. This should lead to an overall reduction in geopolitical risks. That said, the Phase One trade deal remains, and bilateral trade will likely still be an important agenda in future U.S.-China dialogues. Therefore, in the event that geopolitical tensions make an unexpected return, it could lend some boost to the USD and dent the appreciation of the RMB.
Given Mainland China’s restrictive capital controls, access is not readily available for everyone and can be operationally quite complex. Fortunately, the offshore renminbi (CNH) market in Hong Kong is more freely accessible and has high correlation to onshore CGBs. In addition, qualified investors have gained access to the onshore market through various government programs, e.g. Bond Connect, and investors can participate in such managed products.
Putting it all together
China’s export outperformance has helped the economic recovery, and supported the RMB in 2020. Even though some COVID-related export demand, such as medical equipment, should ease when we transition into a post-COVID world as a vaccine becomes increasingly likely, there are fresh tailwinds for trade as well. The biggest tailwind is the global economic recovery, which we believe will strengthen in 2021. The recent signing of the RCEP as well as fading geopolitical tail risks under a Biden administration are additional supporting factors.
As such, we think China’s exports will remain resilient in 2021. This, alongside robust domestic demand recovery, will help to maintain China’s economic growth, and interest-rate premium over other major economies. The RMB is therefore poised to stay strong, particularly versus the USD in 2021. A sharp slowdown in global growth and a return of the trade war are risks to this view.
The combination of a compelling yield advantage (particularly longer-dated bonds), low volatility, and a stable currency makes a strong 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.
RISKS IN INVESTING IN CHINA GOVERNMENT BONDS (CGBs): Investing in fixed income products is subject to certain risks, including interest rate, credit, inflation, call, prepayment, and reinvestment risk.
