Market Views: Clearing the China bond hedging hurdle
With overseas holdings estimated to account for around 4% of the $13 trillion Chinese onshore bond market, it is hard to resist the idea that there is a potential tsunami of investment capital beyond China's shores waiting to make landfall.
Pressure is certainly building. For all the froth, the fact remains: global index providers are pressing ahead with plans to include Chinese onshore bonds in their benchmarks, in spite of the US trade tensions gnawing away at Chinese growth and business prospects.
The latest of these moves is by JP Morgan’s Government Bond Index Emerging Markets (GBI-EM) series of indices. This comes after the inclusion of Chinese government bonds in the Bloomberg Barclays Global Aggregate Index, which is tracked by some $2.5 trillion worth of assets under management.
The implication is that bond funds tracking these indices will have to start adding onshore Chinese bonds to their portfolios. Build it and they will come, as the saying goes.
But will they? Index provider FTSE Russell has its doubts. It announced on Friday that it will not include China in its flagship government bond index, due to concerns over market liquidity and foreign exchange in the country's debt market.
Aside from the lack of liquidity in some sections of the Chinese bond market, a lack of hedging tools also concerns would-be investors. Bond futures and repos, for example, are only available to some foreign investors, according to the Asia Securities Industry & Financial Markets Association.
It's why the People’s Bank of China (PBOC) is reportedly considering making more hedging tools available.
However, there remains a deterrent for some from hedging the currency risk of Chinese bonds: the renminbi is not a freely floating currency. As one executive at a large insurer told AsianInvestor, it's hard for investors to take a view on the direction of the RMB because its movement is controlled by the government.
So how will China broaden the onshore derivatives market for foreign institutional investors? We asked a few investment professionals for their views.
The following extracts have been edited for brevity and clarity.
Jan Dehn, head of research
Ashmore
In order to attract the required financing [from abroad], China’s financial markets must be world class. This places capital account liberalisation, global reserve currency status and the establishment of a domestic financial market with all the bells and whistles at the very centre of China’s reform agenda.
Having already achieved entry into the IMF’s SDR [Special Drawing Rights] basket and great strides forward to join global fixed income benchmarks, the focus is now shifting to derivatives without which no domestic market is complete.
Foreign investors need currency forwards to hedge FX risk, while bond investors require interest rates swaps (IRS) to take the other side of long bond positions. China has already made great strides here too. PBOC has established an offshore IRS markets as well as an onshore FX forwards market (via the new 159 circular).
It is many of the buy-side firms, not the PBOC, which are the laggards with respect to arranging onshore FX forwards mainly due to the inability of custodians to navigate the process. Still, the current suite is largely sufficient for basic real money investors to operate effectively in consideration of upcoming and ongoing index inclusion.
Regardless of government intervenction [in the currency market], there is plenty of hedging demand, regardless of government intervention. Also, RMB is clearly getting more floating with time, so hedging will only get more important.
PBOC is likely to open up bond futures, repos, onshore IRS and possibly onshore FX options to all foreign investors. Currently sovereign names are the only ones with access to most of these, but over time these products will be made available to all registered investors.
Gary O’Brien, regional head of custody product
BNP Paribas Securities Services
The Chinese authorities have introduced a number of new investment opportunities for international investors including the announcement of the possibility to undertake futures trading, securities lending and margin lending.
At the same time, international investors have also helped to highlight enhancements they believe would offer the different access schemes greater investment allocation and ability to mitigate risk. These enhancements vary depending on the scheme. For China-Hong Kong Stock Connect and China-Hong Kong Bond Connect, the focus is on solutions like securities lending and repo activity, in keeping with what is approved for the onshore schemes.
We acknowledge the important role that derivative activity plays in enhancing returns and reducing risk for investors. We point to the important part such instruments play in investment strategies for asset managers in many markets globally.
Continued discussion between onshore regulators and investors to provide guidance on the benefits of different instrument types to institutional investors’ portfolios is key to ensuring the right evolution of the onshore market. To this end, we would propose that the first review could be to highlight traditional derivative instruments that are not yet available to international managers in the Chinese market, with an initial focus on FX derivatives, swaps and option trading, to see how they could be integrated into the Chinese market.
While some of our clients find the hedging topic in relation to renminbi a little challenging, they are keen to have access to the solutions and options they see in other markets so they can make an informed choice as their exposure to the market continues to increase.
Vanessa Chan, investment director, Asian fixed income
Fidelity International
Derivatives are widely used in global bond markets for risk management and to hedge a position, to provide protection against the risk of an adverse move. Currently, onshore participants can trade China government bond (CGB) futures and IRS, while foreign investors are yet to have access to CGB futures.
The availability of derivatives can be a precondition, or part of the considerations, for index inclusion.
Bloomberg/Barclays Global Aggregate index indicated [that the] presence of sufficient interest rate derivative products was considered when it announced including China into its index. Whilst the most recently announced JPM GBI-EM Global Diversified index inclusion stated that fixed income derivatives [were] not a precondition for inclusion.
The next potential index inclusion, which is likely to be the FTSE World Government Bond Index series, stated that a sufficiently developed and liquid fixed-income derivatives market will be one of the considerations.
As index inclusion continues to push forward, it would be a natural evolution for CGB futures to be accessible for foreign investors.
*Joe Marsh contributed to this story.
Story updated to reflect announcement of FTSE Russell on not including Chinese government bonds in its index.