The Daily Update - Bond Connect - The Story Continues

As we mentioned, in yesterday’s daily, we expect Chinese government bonds will SIGNIFICANTLY outperform as the internationalisation of the renminbi continues.

So, the fact that investors will hold more renminbi in the future is a close to a certainty as one can get in the uncertain global financial markets; the only real debate is how these holdings will eventually come about. The flip side of increased flows into China is obviously outflows from elsewhere. Clearly, the major markets like US Treasuries and German Bunds will see some selling pressure, other things being equal, but as the future weight of the Chinese bond market in the Bloomberg Global Agg Index is estimated to be only 5.5%, the selling pressure is likely to be easily absorbed.

More intriguingly the estimated weight of China in the JP Morgan EMBi is 33% (uncapped). Clearly, as fund managers reallocate towards China away from other parts of the EM universe, the currencies that are likely to come under most pressure are the more indebted countries. In an environment of Fed tightening where countries are being forced to compete for an increasingly shrinking global pool of capital, particularly in US dollars, the more indebted are going to be the most vulnerable.

Three countries we would highlight would be Hungary, Turkey & Brazil. All three have net foreign liabilities above 50% of GDP which is a level identified as being associated with financial trouble. So whilst bond connect is clearly a benefit for the renminbi and the Chinese bond market, that comes at the expense of some emerging countries who have a disproportionately large weight in the indices owing simply to their large levels of indebtedness.

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