A question, posed innocently enough, by Citigroup Inc. analysts earlier this month.
It is difficult to overstate the importance of benchmark indexes within markets. They are the "bogeys" against which large pension funds, asset managers and insurers measure their returns. In an age of passive investing they also exert an outsized influence on the fortunes of billions of dollars worth of assets, able to send vast amounts of money into or out of a particular bond or stock by dint of its inclusion or expulsion.
Last month, China moved to further open its bond market to a range of foreign institutional investors who would now be able to tap the onshore interbank debt market far more easily. The move comes as China is believed to be worried about investor outflows that have driven the yuan to five-year lows.
It has also prompted some analysts—such as those at Citi—to wonder whether there may eventually be a time when the world's third-largest debt market is included in benchmark bond indexes. For Citi's purposes, those benchmarks are its World Government Bond Index (WGBI), Asian Government Bond Index (AGBI), and Emerging Markets Government Bond Index (EMGBI).
Unsurprisingly perhaps, the inclusion of Chinese sovereign debt in such indexes would crowd out some existing constituencies. When it comes to the WGBI, for instance, U.S. debt would be the worst affected, with its weight dropping by about 1.55 percent according to Citi. That would be followed by the eurozone and Japan, with a drop of 1.44 percent and 1.08 percent respectively.
China's effects are more pronounced on the EMGBI, which would move from a relatively well-balanced emerging market index to one overwhelmed by Asian debt. "Mexico’s weight would fall by around 9.45 percent, whilst Poland and Indonesia would decline by 5.82 percent and 5.36 percent respectively, as the benchmark would in effect morph into a China dominated index with more than half its market value located in China," Citi said.
But perhaps the most intriguing questions surrounding the potential inclusion of Chinese debt stem from its impact on investor returns.
"For the WGBI universe, the addition of China would generally offer some yield pickup during times when yield can be scarce," Citi Analysts Terence Scheit and Hing Wong wrote in their research. "Within an emerging market context, China inclusion would put a brake on yields, but ... a benefit may arise through the impact China has on [lowering] overall volatility."
In pic form, that yield pick-up looks something like this:
Of course, benchmark inclusion often has unintended effects on the assets involved. While Chinese government debt has outperformed on a risk-adjusted basis—thanks in part to low volatility being one of the benefits of a closed and controlled debt ecosystem and currency regime—that could quickly change as the market becomes more liberalized and is consequently propelled into benchmarks.
"Although historically China inclusion would have been beneficial in terms of greater returns or lower volatility, we would caution that the very factors which may be leading to China inclusion could limit the value of such past behavior as a template for the future," the Citi analysts conclude.