The Daily Update - Further China government bond inclusion

This week Citigroup Inc announced that China’s onshore bonds will be included in three of its government bond indexes from February 1 2018. This news follows the announcement last month from the Bloomberg Barclays Fixed Income Indices of new parallel global indices which include China renminbi (RMB) denominated securities. The assets under management for funds tracking Citi’s indices may be relatively small, however, the new weights will surprise many investors who have neither been following the RMB internationalisation story nor are aware of the scale of the Chinese bond market. According to Citibank, the weight of China in their existing Emerging Markets Government Bond Index will rise from zero to a huge 52.5%.

Once included, the scale of shift towards Chinese government bonds may be modest initially, however the direction is very clear. Unless funds following these indices increase overall, there will be a shift away from the existing components in favour of China. At Stratton Street we use net foreign assets as a measure of a country’s overall assets or liabilities; China ranks well on this measure being a net creditor nation. In contrast, Brazil for example is a major debtor. As investors rebalance, which may take time, there will be a natural shift away from debtors to creditors which has important implications for correcting global imbalances were the reallocation to become more widespread.

We are not currently invested in the onshore bond market, only because our preferred strategy of buying investment grade liquid dollar bonds and hedging into CNH, across our Renminbi Bond strategy, is very profitable for us at the moment. It doesn’t mean that we don’t think onshore bonds are attractive, we just have a preference to invest elsewhere. For example, the one-month CNH forwards are priced to give an implied annualised yield of around 7% (the 45-day yields as much as 8.7%!), which is way above anything that can be achieved in local markets for similar credit quality.

Most investors, even some of the largest firms in the world, do not even have a cash position in RMB. Were these investors more forward thinking, they would realise that China’s offshore and onshore bond markets present an opportunity, and those holding RMB assets now are likely to outperform those who follow later. It may take time for investors to acknowledge that the world is changing, but it is inevitable that investors will hold more RMB in the future than they do today.

Although the widely held opinion is that the RMB is relatively weak, we disagree that notion. Weak relative to what? True, over the past 12 months the RMB has declined against the dollar and many other emerging currencies, but over the last three years the only major currency to outperform the RMB has been the Japanese yen, which gained ~1.5% against the redback.

Our assessment is that investors have a false perception of the relative strength of the RMB and consequently think the bond market is unattractive. It’s a big perception problem for China, which is largely due to international investors and press outlets misunderstanding the comments from Chinese officials. China has an incentive for a stable or stronger RMB and that message has been unheeded by international investors. Maybe China needs to adopt a strong RMB policy like the US which supposedly has a strong dollar policy to change investor perception.

If we are right about the future for the RMB, a world in which countries like China with large current account surpluses see their currencies appreciate, then investors in indices without RMB will likely underperform those that follow indices which include the Chinese currency. Consequently, RMB strength will likely lead to a shift in the preference of fund managers who will want to track the better performing indices rather than the outdated versions that exclude the currency of the world’s second largest economy.