China Losing Appeal to World Just as It Opens Bond Market Widerby
Yuan depreciating as China yield advantage to U.S. shrinks
Foreign investment needed amid outflows, growth slowdown
The two best reasons to buy Chinese bonds are fast fading.
The yuan, once Asia’s best carry trade, closed at a four-year low this week and the yield advantage of China’s sovereign debt over U.S. Treasuries fell to the narrowest in five years. Currency appreciation bets and higher yields drew 93 billion yuan ($14.4 billion) into Chinese bonds from foreign investors in the first half. Their holdings shrank 2.4 percent in August, the most since the data started in 2014, as the Federal Reserve prepared to increase interest rates while the People’s Bank of China cut borrowing costs.
"There’s not much to gain from buying Chinese bonds," said James Yip, a Hong Kong-based fund manager at Shenwan Hongyuan Asset Management (Asia) Ltd., which invests offshore yuan in onshore markets. “Yields are low and currency depreciation is forcing investors to use offshore protection to hedge the risks. The appeal is much, much less than one or two years ago."
The fading draw of Chinese bonds challenges President Xi Jinping’s push to broaden global use of the yuan, which just last month won entry into the International Monetary Fund’s basket of reserve currencies. Foreign capital is also needed to offset ongoing domestic outflows, which are threatening to destabilize the exchange rate and push up borrowing costs amid the slowest economic growth in 25 years.
Overseas investors’ Chinese bond holdings rose 14 percent in the first three quarters to 764.6 billion yuan, compared with a 68 percent increase in 2014. Foreign ownership will rise 10 percent next year to 900 billion yuan, Gu Ying, an emerging Asia currency and rates strategist at JPMorgan & Chase Co., predicted in a Dec. 9 report. That would be the weakest expansion since the onshore bond market was opened to overseas funds in 2009.
“The perception around yuan stability and the fact that things have to be more flexible have obviously changed the appeal of Chinese bonds,” said Joel Kim, the Singapore-based head of Asia-Pacific fixed income at BlackRock Inc., which oversees $4.5 trillion. “Clearly yields have gone down as China has been easing policy.”
The gap between Chinese and U.S. five-year government bond yields has narrowed 70 basis points this year to 116 basis points, less than half the record 319 basis points in 2013. Twenty of 24 economists surveyed by Bloomberg expect the PBOC to lower the benchmark rate further in 2016 after delivering six cuts over the past 13 months. As for the U.S., futures are pricing in 64 percent odds of the Fed funds rate being at least 0.75 percent by end-2016, compared with the current effective rate of 0.14 percent.
Global interest is waning just as China widens foreigner access. In July, authorities made it easier for sovereign wealth funds and overseas central banks to trade in its interbank bond market, among a swathe of measures allowing the yuan to enter the IMF’s Special Drawing Rights.
Sustained outflows have made attracting capital all the more urgent. Foreign-exchange reserves fell $87 billion to $3.44 trillion last month, more than double the $33 billion drop forecast by economists in a Bloomberg survey, as the central bank sold dollars to prop up the yuan. Bond supply is also increasing due to a rising budget deficit and a three-year, 15 trillion yuan program to swap local governments’ higher-yielding debt into municipal securities.
Even investors eyeing capital gains from onshore debt may be disappointed. The 10-year government bond yield will rise from 3 percent on Thursday to 3.2 percent at end-2016, ending a two-year rally, according to the median estimate in a Bloomberg survey of analysts. The comparable U.S. yield will rise 55 basis points to 2.78 percent at the end of next year, a separate survey showed.
Demand for Chinese assets may be given a boost by the increased use of the yuan in international trade, said Shenwan Hongyuan’s Yip. The currency was the fifth most-used for global payments in October, accounting for 1.92 percent of the total. It ranked seventh a year ago.
"As the percentage of trade settlement done in the yuan rises, many people will have a demand for yuan assets because they’re already holding the currency," Yip said. "If your base currency is the yuan you may not care about the exchange rate’s moves."
The central bank has weakened the yuan’s fixings and reined in intervention since its SDR entry in a move to give the market a "stress test" before the Fed’s meeting next week, said Zhou Hao, a Singapore-based senior economist at Commerzbank AG. The currency fell for a sixth day on Friday to 6.4496 a dollar as of 1:32 p.m. in Shanghai and is expected to weaken 2 percent by the end of 2016, based on the median forecast in a Bloomberg survey of analysts.
"Investors have to consider whether the interest-rate differential is enough to offset the depreciation they have to endure when they buy Chinese bonds," said Hao Hong, the chief China strategist at Bocom International Holdings Co. in Hong Kong. "We’re not at a stage of significant capital inflows. As a result, I think the yuan’s exchange rate should reflect more of the economic fundamentals rather than capital inflows."