By Diliana Deltcheva, Head of Emerging Markets Bond Management and Julien Fabre, Emerging Market Debt Fund Manager
The launch of the Stock Connect platform in 2014 was the single biggest step towards opening onshore capital markets to foreign investors. The launch of the Bond Connect Northbound platform beginning July, is only a small step in the long road of liberalizing capital markets in China. Allowing foreign investors an easier access to Chinese capital markets is an intentional policy pursued by Chinese policymakers in order to assert the Renminbi as an international currency and to balance the pressures on the financial account and the currency.
Risks around the deleveraging of the Chinese economy are high in the medium term and these risks are not fully priced in by Chinese assets at the moment.
In anticipation of the Party Congress this year, the government managed to delay the much awaited rebalancing of the economy, and the restructuring of the heavy-manufacturing SOEs sector. Deterring capital outflows has been part of this artificial stabilization. In 2014-15, foreign investors have experienced the policy and communication faux-pas of the Chinese government, as well as the effect of opaque governance at the level of the State, the banking and corporate sectors. Since 2016 though volatility in FX and equity markets has subsided and now most analysts agree that any leverage unwinds or a ‘Chinese hard landing’ will only materialize in the medium term. We, therefore, believe market positioning in the currency is neutral. The combination of high policy risk and lower attention on the part of investors could prove dangerous.
We remain prudent and keep a short position on the Renminbi as a hedge against Chinese risks in our local currency emerging debt fund.
We will not rush to buy Chinese government bonds (CGBs) and local currency denominated corporate bonds since we do not find them sufficiently attractive relative to fundamentals. As a comparison, the GBI-EM GD index offers a yield of 6.3%, whereas CGBs offer yields of 3 to 4%, and 5% for higher quality corporates. We are invested in a number of disinflation stories in which we have high conviction, like Russia, Brazil, Turkey and South Africa, that yield between 8% and 12%. The 17 emerging GBI-EM GD member countries, have, sufficiently open financial accounts and easier to track fundamental, valuation and technical drivers that we can base our investment recommendations on. We cannot extend our relative currency and local bond analysis easily to China as the quality and reliability of data is not yet fully reliable.
Beyond the medium term deleveraging risks, China is not at a point of its business cycle when investors would find duration attractive. China is in the midst of monetary and financial tightening as the PBOC is attempting to engineer an orderly deleveraging of the shadow banking system. That process is likely to continue as long as the pain for the economy is manageable. The impact of the tighter financial and liquidity conditions on the government yield curve is, at best, undetermined, and on corporate credit - is outright negative. We therefore see a stronger case for capital outflows and currency depreciation rather than inflows into the local bond or equity markets.