As April Fools' Day jokes go, they potentially do not get much bigger than China’s inclusion into three of Bloomberg’s bond indices. And it is certainly not one that any financial market participant wants to be on the receiving end of as they watch Chinese bonds start to take their rightful place on the international stage.
Index inclusion represents a transformational event on many levels. As former US policy advisor Jimmy Carville once said - if re-incarnation existed then he wanted to come back as the bond market because it gets to intimidate everyone.
And that is exactly how many foreign fund managers are feeling right now as they face the prospect of having to get to grips with China’s $12 trillion domestic bond market.
Last year, foreign investors poured in $81 billion. But the real change begins today as Bloomberg phases in a 6% weighting over the next 20 months.
Within the next couple of years, other index providers such as FTSE-Russell (owner of the World Government Bond Index) and JP Morgan (Government Bond Index – Emerging Markets) are expected to follow suit.
In the following interview, Hayden Briscoe, head of Asia Pacific fixed income at UBS Asset Management, explains why he is so bullish about the market’s long-term prospects but worries the world is not ready to cope over the short-term.
Q There have been lots of predictions about potential inflows into Chinese bonds. What’s your view?
A This is undoubtedly the single largest change the capital markets will experience in anybody’s lifetime. It’s seismic.
We estimate that if you add the 6% weight to the Bloomberg indices, plus further inflows from central banks and sovereign wealth funds (SWFs), then we are looking at $3 trillion inflows over the next couple of years.
Lots of people have focused on expected inflows from institutional asset managers this year. But I think they’ve underestimated just how much more money will come in from central banks and SWFs. Every time I meet government officials, their opening gambit is always about how to get access to more RMB? "I’m going to double my allocation to Chinese bonds this year," is what they typically say.
This is a market that no one can ignore. It’s already the world’s third largest and we think it will double in size and become the world’s second largest in the next five years.
Q And initially, all that money will head into Chinese Government Bonds (CGBs) and policy bank bonds?
A Yes, but I think the other issue on which investors need to focus is corporate credit. China already has the second largest market in the world and we think it will be the same size as the US within the next five years.
Corporate credit will also be included in the indices as soon as the Western credit rating agencies are allowed to publish their onshore ratings publicly. Then China’s weighting will jump from 6% to 10%.
There’s a slight crinkle. S&P and Fitch are going to use the Chinese standard, which assigns triple-A ratings for investment grade credit and double-A ratings for high yield.
Only Moody’s has said that it will stick to its global standard once its application is approved. That’s the one that would trigger corporate inclusion.
Q When’s that likely to happen?
A Within the next two years, I’d say. Within the next five years, I think China will account for about 20% to 25% of global indices and that means inflows north of $10 trillion.
If China went into the emerging market indices then it wouldn’t have been so much of a problem because far fewer asset allocators track them. But it’s going into the developed indices and the problem is that fund managers running global products can’t ignore China. It’s just too large.
Q Are global fund managers ready?
A No, they’re not.
Most houses don’t even have dealing desks set up. They don’t have portfolio managers who know anything about Chinese bond markets. They’ve never dealt onshore. They don’t have credit analysts. I could go on.
There’s going to be a mad scramble for talent over the next five years. Unfortunately, I’m only half joking when I say that I can only count the number of people who meet the relevant criteria on one hand.
And those people are still babies really. In Asia, you’re considered a veteran if you have five years experience.
Yet who in China has been through a full default cycle? Onshore credit analysts are only just starting to experience more macro volatility too.
Over the longer-term, these huge changes will be good for China and the world. Capital will get allocated more efficiently as China moves from relationship-based lending to the bond markets. But over the short-term, new market forces and regulations will create unexpected feedback loops.
Another big consideration is that Chinese government bonds only trade during Asian hours. So if you’re based in the US what are you going to do? This is going to be a big shocker for America.
Other major government bond markets trade 24 hours through global clearers like Euroclear. However, Chinese bonds trade through CFETS and have to be settled in Renminbi.
But the main problem isn’t the plumbing. It’s the price makers.
They’re all Chinese banks and they haven’t internationalised fast enough to keep pace with the market opening. They’re still largely based in China.
Q Are you all set up?
A Everyone has been scrambling to get ready and it’s been tough for us too. We’ve got a whole project team working on this, getting our 40 funds signed up.
Take the counterparties we need to sign up. We want about 350 onshore. I worked out that if I assigned just one person to approve them all, it would take two-and-a-half years.
Another challenge concerned our desire to set up a trading desk in Shanghai. There aren’t any tax rules. Right now, we’d fall under advice, which would make us subject to private equity taxation.
This means that if a dealer does anything for a global fund outside of China then it’s subject to 30% worldwide tax. Therefore our dealers need to sit offshore to trade onshore.
Q You seem to be saying that everything’s happening too fast. Has Bloomberg jumped the gun because it wants to sell lots of terminals in China? This must represent a golden opportunity given it has about 325,000 terminal subscribers globally whereas domestic competitor Wind already has one million?
A Obviously, I can’t answer for Bloomberg. But what I can say is that it’s been investing in a lot of Chinese content. I can sit on a terminal and hit translate and it changes to English straight away.
The plumbing is there. That’s not the issue. It’s the lack of people as I said before.
You have to hand it to the Chinese. They’ve done everything they needed to meet the inclusion criteria. We sit on the boards and were part of the deliberations with the regulators and index providers.
The Chinese have always been very open. They said: “you gave us a list of everything you wanted and we met it – settlements, no quotas, trading systems etc.”
But yes I don’t think the Western firms have invested enough. They’re getting forced into this.
Q Can China handle the inflows?
A History shows that countries typically encounter problems when they open up. Even the US fell victim to the savings and loans crisis in the 1980s.
The excess money typically ends up in housing. But I don’t think that will happen in China’s case. I think the excess money, which the banks will end up with, is far more likely to find its way into the stock market.
If everyone decides that they’re only going to hold government and policy bank bonds, however, then there won’t be enough to go round. The government will have to issue more and then sterilise the proceeds.
Understanding how it does that will be one of the most important issues with which we’ll need to get to grips. When it came to its trade surpluses, China sterilised the surplus by investing in US Treasuries.
Q How worried should foreign investors be about defaults?
A Defaults are currently doubling each year but from a very low base. The overall rate amounts to less than 1% of lending. That’s pretty healthy for a country that big and that diverse.
I also think that China’s default mechanisms work well now. The courts have changed. Creditors can go through the default cycle and get their money back.
Q Do you think that foreign investors can help finance China’s private sector? Will they favour POEs because they’re better run than state-owned enterprises (SOEs)?
A I think they’ll go for strategically important SOEs like the railway companies or Three Gorges Dam because investors like the state backing. Even though some of the SOEs debt metrics might not look great because they’re highly levered utilities, investors know the government will continue to support them.
Q What do you buy?
A We’re predominantly in CGBs and policy bank bonds. We’ve never bought a single Local Government Financing Vehicle (LGFV) bond because there’s no secondary market liquidity.
We also own strategically important SOEs and have done for years.
Q What do you tell clients about how they should approach this new world?
A We say that we fully understand their concerns about credit and visibility. But they need to start investing in research and start thinking about this from a strategy perspective.
Most CIOs don’t have a bucket which says China on it because they’ve not been able to access the market before. We get a lot of questions about where China should fit in their asset allocations.
We think that China is a good fit for global aggregate funds. If you look at the world since 2008, there’s been a big structural break as yields have collapsed.
European interest rates are at zero. Japanese rates are at zero. Investors have been getting more and more boxed into the US.
But they still need to satisfy their income requirements so they’ve pushed into emerging markets instead. That’s hit the income side but lifted the overall risk in their portfolio.
China, on the other hand, offers one of the highest real yields for managers running multi-asset portfolios. It’s got a liquid market that’s big enough to participate in.
Most people also don’t realise that CGBs act like US Treasuries and are negatively correlated with risk assets. If an investor is looking for income, a bond market that can rally and one that has defensive characteristics, then China ticks all the right boxes.
Q Does this pose a risk for EM debt? And doesn’t it also mean that Chinese yields should compress pretty quickly?
A It could hit EM. Where Chinese yields are concerned, I think the outlook is positive.
I think that high growth rates are here for potentially another decade. Over the next five years, China’s on a path from 6.5% to 5%. But the economy will become a lot more balanced because there’ll be less reliance on heavy industry and more on consumer-led demand and innovation.
Q What’s your view on how all this will affect the internationalization of the RMB?
A The Global Financial Crisis of 2008 was a cathartic event for China. Since then, it’s been proactively reducing US dollar-denominated settlements.
One of the most pivotal moments came a year ago when it set up the oil contract that settles in RMB and gold. That now accounts for 18% of the world’s oil market.
It’s like history replaying itself. It’s exactly what Kissinger did in the 1970s with the US dollar.
What you have now are Middle Eastern central banks and SWFs selling their oil into the Chinese contract, getting paid in RMB and re-cycling that cash into CGBs.
The same thing has happened with other commodities like iron ore, which have all been listed on the Dalian Stock Exchange.
One of the other unique aspects about China is the way it manages its currency to the CFETS basket, which is essentially trade-weighted. At some point in the future, I think they’ll add a currency component to the basket and that will reduce FX volatility.
Q This doesn’t sound good for America’s “exorbitant privilege”?
A It’s hugely positive for the world because the US Federal Reserve’s policy is driving global macro-volatility. We need someone to counter them.
We were hoping it was going to be Europe and Japan, but it never happened. The world will benefit from trade being denominated in another currency.
Trade used to be three times world GDP. It’s now less than one times. That’s not because growth has slowed down but because Asia no longer needs to take products from Europe and the US and re-package them in the region.
There’s a de-synchronisation taking place. Asia-Pacific was lowering interest rates as the Fed was raising them.
Q You were the first fund to launch a CNY-denominated Luxembourg-listed fund. I presume you’re very optimistic about its prospects?
A Right now it’s quite small. Assets under management stand at slightly under $100 million.
But two Japanese distributors (a bank and securities house) have started to invest in the fund, so it’s starting to ramp up. In Europe and Asia, we’re getting a lot of interest from family offices.
This is the beginning of the end for the CNH currency market. I look at it in a similar way to the ECU in the 1990s which became fungible into the euro.
CNH is still the world’s fourth or fifth most actively traded currency. But I don’t need it anymore.
The Chinese have been very smart. They’ve allowed Hong Kong banks to settle CNY directly onshore. That means I can do spot and forward trades with those entities for which I’ve got the piping open.
This just accelerates the process even faster now. RMB utilisation is just going to go through the roof.
Whenever we leave a client meeting we always emphasise how important it is to start understanding all of this. We tell them that even if they don’t want to buy a Chinese bond now, they really need to start researching this market. It’s a new world and it’s going to be quite a shock.
