China’s Index Entry Signals New Phase for Emerging Markets Debt
Fran Rodilosso, CFA, Head of Fixed Income ETF Portfolio Management
September 26, 2019
J.P. Morgan has become the latest index provider to announce that China’s onshore local currency bonds will be eligible for inclusion in its local currency bond indices, including the J.P Morgan GBI-EM Global Core Index. Beginning in February 2020, eligible bonds will be phased into the index at 1% per month until the maximum weight of 10% is reached. When fully implemented, the index is expected to have a somewhat lower overall yield, but it will also be more diversified and have a more conservative risk profile, given China’s investment grade rating and relatively stable currency. According to J.P. Morgan, China’s entry into major global indices represents a new phase for the emerging markets fixed income asset class—one that is supportive of a strategic allocation, given the low/negative yields and slow growth in developed markets and the trend towards higher rated emerging markets debt.
Investing in China: Growing Access to Chinese Onshore Bonds
J.P. Morgan’s announcement was widely anticipated, and other index providers have already begun including bonds issued in China’s vast onshore bond market. With over $13 trillion in bonds outstanding, and $5 trillion of government debt, China’s bond market is the second largest in the world behind the U.S. The country’s representation in global debt benchmarks does not reflect its size, and foreign participation in the market is still extremely low at less than 3%. However, that is expected to increase, contributing to broader and deeper liquidity in the local markets. It is anticipated that inclusion in major fixed income indices will result in $250 billion - $300 billion of inflows from foreigners.
Inclusion in major global bond benchmarks is the next step in what has been a very gradual and deliberate opening of China’s capital markets to foreigners. Beginning in the early 2000s, China introduced the Qualified Foreign Institutional Investor (QFII) program, which allowed certain foreign investors to invest onshore, with limits including a quota on the amount they could invest and restrictions on repatriation. Over the years, new programs to access the onshore bond market—such as the Renminbi Qualified Foreign Institutional Investor (RQFII) program, Bond Connect and Direct interbank access—have been introduced that have gradually removed an onerous application process and, for the most part, removed restrictions such as lock-up periods. This month, Chinese regulators announced that the investment quota limitations of the QFII and RQFII programs would be removed.
Key Steps Taken to Expand Foreign Investor Access to China
1990: Modernized Capital Markets National stock exchanges established as self-regulatory organizations (A-shares).
1992: First H-Shares Listed Nine Chinese state enterprises listed on the Hong Kong Stock Exchange.
2002: Qualified Foreign Institutional Investor (QFII) Allows global institutional investors to invest in China’s RMB denominated capital market.
2007: First Dim Sum Bond Issued Dim sum bonds allow bonds to be issued outside of China, but denominated in Chinese renminbi.
2011: Renminbi Qualified Foreign Institutional Investor (RQFII) Allows subsidiaries of domestic fund management companies and securities companies in Hong Kong to invest in mainland securities market.
2014: Shanghai-Hong Kong Stock Connect Links Shanghai Stock Exchange to Hong Kong Stock Exchange, allowing investors to trade shares across markets.
2016: Shenzhen-Hong Kong Stock Connect Links Shenzhen Stock Exchange to Hong Kong Stock Exchange, allowing investors to trade shares across markets.
2016: China Interbank Bond Market (CIBM) Foreign institutions can trade bonds directly through banks holding a Type A license.
2017: China Bond Connect Trading link that allows offshore investors access to the domestic China bond market in Hong Kong.
2018: Easing of Restrictions for QFII/RQFII Regulators removed a 20% monthly cap on repatriation and also removed lockup periods for investment principal. Foreign investors now able to use QFII and RQFII to hedge onshore currency risk.
2019: Removal of QFII and RQFII Quotas Regulators announced removal of QFII and RQFII inbound investment quotas, potential consolidation of the two programs and expanded eligibility for foreign investors.
China’s Evolving Economy
What’s driving this gradual opening? In short, the evolution of China’s economy from one based on manufacturing to one that is more consumer-led. As China’s share of exports shrinks and domestic demand for imports grows due to the country’s rising wealth, its trade surplus has been declining and may soon become a trade deficit. There is also a desire to reduce reliance on domestic funding sources, including the shadow banking sector and wealth management products. Foreign investment is therefore needed to fund future growth, and explains the increased efforts to attract relatively stable sources of capital from foreign institutions. Further, China’s desire to promote the renminbi as an international reserve currency would be incompatible with capital markets that remain closed off.
The doors are now open for foreign investment, but many investors remain cautious. A primary concern is that the doors are closed in periods of market stress. Many foreign investors want to see the new programs tested, to provide assurance they can get their money out when they need to. Time will tell, but the Chinese economic transition is in full swing, and we believe it would be extremely difficult for policymakers to backtrack on the significant reforms that have been implemented. Emerging markets bond investors may choose to gain exposure through diversified portfolios to help limit potential risk. Alternatively, they may consider a China-only bond strategy to tailor their overall exposure to China’s bond market, including exposure to corporates or policy bank bonds that are not going to be included in global emerging markets bond benchmarks.
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