After explosive growth, China’s bond market provides diversified investment options to Chinese and foreign investors. But should you believe the hype, China’s bonds are overshadowed by fatal defaults.

Dan Steinbock

As a result, these reports systematically undervalue financial future in emerging economies, while overvaluing those in advanced economies. That’s misleading to investors at a historical moment of transition when financial might is following economic power toward emerging economies.

Low foreign participation as an investment opportunity
Rather than a great one-time opportunity for foreign investors, the low share of these investors in China’s bond market is often portrayed as a major liability.

Here are the realities: China has the world’s third-largest bond market, which was valued at about $12 trillion in year-end 2017. Currently, foreign investors own only 1.6 peercent of the total market. That is not a problem, but an investment opportunity.

Here’s why: Since the early 1990s, the Chinese bond market has achieved an annualized average growth rate of almost 40 percent. Just as Chinese industrialization took off in the late 20th century, China’s financial sector is following in the footprints, but with a time lag.

Let’s put the time lag in context, however. In the US, the Treasury bond market was created as part of the funding plans for World War I. In other words, it took almost 140 years of independence to create the first bond markets in America. In China, the bond market was created in the early 1990s; barely 40 years after China’s independence –more than three times faster than in the US.

It is the historical pace and structural importance of the Chinese bond market to ordinary Chinese and Beijing’s central government that should make it attractive to international investors as well.

Here’s why: After four decades of the most rapid catch-up in world history, Chinese per capita incomes, adjusted to purchasing power, are today on average about $18,100; or 30 percent of those in the US. In America, multiple generations have contributed to the bond market; in China, barely one.

Due to the lower prosperity levels of individual Chinese and Beijing’s national growth plan, the Chinese bond market is a priority for the well-being of Chinese families and for Beijing’s economic welfare plans – a priority that can now benefit foreign investors as well.

China’s impending financial expansion
In the past four decades, China’s economy has grown almost six-fold to more than 12 percent of the global economy. In the future, that share will continue to expand, as evidenced by the Chinese contribution to global growth, which has been around 30 percent since the 2008 global crisis. This is about 2.5 times more than its current share of the global GDP.

Relative to its rising economic importance, China’s role in the global financial market was limited until the early 2000s, however. Financial reforms started with pilot programs a decade ago and have dramatically accelerated, along with the internationalization of the renminbi. At the same time, sovereign paper, which dominated the bond market until the late 2000s, has been augmented by corporate bond issuance, particularly after the global crisis.

Today, the rapidly growing Chinese bond market comprises an expansive mix of sovereign, quasi-sovereign (policy banks), sub-government (municipal and state-owned enterprises, SOEs) and corporate bonds.

Moreover, the rapid growth of the Chinese bond market is not likely to be exhausted any time soon. By 2020, China is likely to catch up with Japan as the second-largest bond market in the world.

Indeed, the Chinese bond market has much more space to grow: relative to the $12 trillion economy, the bond market is less than 100 percent of China’s GDP. This ratio is far smaller than those in major economies. For instance, in the US, the ratio is closer to 200 percent. And China’s population base is more than four times larger than that of the US.

While cases of defaults and downgrades in the Chinese bond market have increased in recent years, these have remained under the control of the government, particularly regarding the state-owned enterprises (SOE) and local government subsidiaries (e.g. local government financing vehicles, LGFVs). Yet, only a decade ago the LGFVs were often portrayed as fatal to China’s economy by a slate of “China crash” theorists in Western media.

Chinese government may even have used some defaults as “demonstration effects” to signal the need for greater market discipline, while the campaign against corruption has enhanced regulators’ grip over potential credit events.

International takeoff
As the gap between media perceptions and investor realities has broadened, many investors ignore media reports that downplay opportunities. According to June data, overseas investors are pouring funds into China’s domestic bonds at record pace, despite what media portray as the “yuan’s jitters.”

The future of Chinese bond market expansion is likely to mimic that of China’s role in the IMF’s reserve currency basket (SDR), which is today 11 percent. That’s less than that of the US dollar (42 percent) and the Euro (31 percent), but more than the Japanese yen (8 percent) and the UK pound (8 percent). For all practical purposes, the Chinese bond market is likely to emulate the SDR allocations, which would imply that foreign participation has the potential to grow at least six-fold. Unsurprisingly, central banks and sovereign-wealth funds were the first to participate in RMB following its inclusion in the IMF’s SDR basket.

In contrast, private-sector investors—pension funds, insurance companies and asset managers—remain largely under-represented. Yet, in the past few years, the likelihood of their entry has been boosted by a number of highly regarded global index operators that have incorporated Chinese assets into their index space, including the IMF (SDR for global reserve currencies), MSCI (global equities) and Bloomberg-Barclays (BBGAI for global bonds).

It is the critical moments of historical transition that highlight the importance of unbiased financial reporting. The coming explosion of the Chinese bond market is a textbook example.

Dan Steinbock is the founder of Difference Group and has served as research director of international business at the India, China and America Institute (US) and a visiting fellow at the Shanghai Institute for International Studies (China) and the EU Center (Singapore). For more, see http://www.differencegroup.net/

This story was originally published by The Manila Times, Philippines