Year of the Rat reflections: China pension investing, and bond market shocks

At the beginning of every Chinese New Year, AsianInvestor makes 10 predictions about economic, political and financial developments that are likely to have an impact on the way institutional investors allocate their funds. And then, one year later, we revisit these forecasts to see how well we did.

Our fifth and sixth Year of the Rat predictions looked at whether the Beijing was ready to begin letting its state pension funds invest overseas, instead of relying on the National Social Security Fund to do so on their behalf, while we also asked whether bond market shocks were likely to take place in 2020. 

Will China allow its pensions to invest overseas?
Answer: No

Verdict: Correct

This was always a rather hopeful question, but the need for China to quickly evolve its state pension industry led us to question whether it was possible that the government would permit a level of direct overseas investing by its local provincial pension funds. 

That looked unlikely even before the onset of the coronavirus. As we noted a year ago, Beijing would be unlikely to let local pensions directly invest offshore when it wanted their assets to bolster the country's slowing economy and as it remained beset by a trade war with the US. Those instincts were only strengthened as Covid-19 spread. 

Indeed, the country's biggest reforms have come on the inbound side, with the first foreign life insurer having just gained permission to establish on onshore asset management division, while a merging of the likes of the QFII and RQFII systems and removing quotas on the two on May 7 were designed to make it easier for foreign investors to put money to work in China's markets. 

Meanwhile the NSSF saw its limit on equity investing raised from 40% to 60% to give it the possibility of generating higher returns and encouraging more long-term funds into China's capital markets. 

True, there have been some efforts on the reverse. A new round of qualified domestic institutional investor (QDII) quotas totally $9.02 billion were approved on January 13, but were targeted at mutual fund managers. In addition there was some limited liberalisation when Beijing allowed annuities retirement funds to invest into equities for the first time, including Hong Kong shares, at the beginning of this year. 

But the only way provincial pension funds can get access to foreign foreign products is via the Connect programmes, primarily with Hong Kong, or through the assets they hand over to the National Social Security Fund to invest on their behalf. That may change one day, but it is unlikely to be soon.

Beijing wants to keep attracting institutional investor capital. It is less eager to let it go. 

Will there be any bond market shocks? 
Answer: No (but China could be vulnerable)

Verdict: Incorrect

Looking back a year, it now seems naive to have questioned whether market shocks were likely. As the world now knows, the beginning of February marked a period in which a once little-known virus was set to dominate the entire world. 

The rapid spread of Covid-19 caused shocks across all financial markets, not merely the bond markets. However, they were among the most badly affected in late February and March, as the scale of the impact of the fast-spreading disease became apparent. As countries closed borders and asked people to stay at home, entire industries suddenly finding their very futures in peril.

It was little surprise, therefore, that there were huge blowouts in bond spreads among many corporates deemed vulnerable, even as safe assets such as US Treasuries or the debt of e-commerce companies rallied. The 10-year US Treasury, for example, saw its yield drop from around 180 basis points at the beginning of 2020 to less than 55bp at points in late March and April.

We had highlighted China's bond markets as being potentially vulnerable, courtesy of years of rising debt spending, which hit 302% of GDP at the end of 2019, plus government efforts to constrain this. And as we noted then, the Covid virus was spreading internally and appeared likely to have big ramifications for its tourism and consumer industries.

As the Covid crisis unfolded Beijing reversed all attempts to constrain its debt, instead opening the floodgates to borrowing to stave off mass unemployment and economc contraction. That may have long term ramifications; the country's overall debt rose to GDP rose to an estimated 335% by June 2020, according to the Institute of International Finance, and will likely have risen further still by the end of the year. 

But opening the taps worked; China was one of the few economies to report positive GDP growth in 2020. True, debt defaults rose - Chinese state owned enterprises defaulted on Rmb71.8 billion ($11.1 billion) of onshore bonds, 51% of the country's total, in 2020, according to the National Institution for Finance and Development - but this could have been far worse.

For the rest of the world the immediate panic around Covid was abated by aggressive and large-scale actions by central banks to demonstrate that they would offer as much liquidity as was needed to prevent a credit crunch. That helped to settle markets, and bring spreads back down once more. By May 1 the yield of US investment-grade corporate bonds over Treasuries declining from over 4 percentage points in March to about 2.2 percentage points, according to the ICE BofA US Corporate Index.

Inevitably, default levels in 2020 rose - Fitch Ratings noted the default rates for US leveraged loans and high yield bonds in 2020 hit 4.5% and 5.2%, respectively - as some businesses were unable to survive amid mass lockdowns and isolations. But it could have been a lot worse.