Chinese local government bonds offer diversification in a world of correlations

China watchers are hard to please. When the country was roaring with double-digit growth, they took issue with its economic model. Too much fixed capital investment, too many wasted resources, not enough attention to quality and on it went.

Now there is hand-wringing that China’s economy is growing at ‘only’ around 7 per cent.

So it was no surprise that naysayers bobbed up again when two local government bond deals were pulled from the market in April owing to insufficient demand. It was a case of rushing to conclusions.

As time progressed, the Jiangsu and Xinjiang government bond auctions turned out to be successes. Interest in the Xinjiang deal was especially strong with oversubscriptions for bonds ranging from 3-10 years maturity.

The two auctions are part of policy reform to facilitate bank investment in local government bonds – an important step towards the creation of a fully developed domestic capital market.

The government announced in March a debt swap program for around RMB1.7 trillion of local government debt (loans) due for refinancing this year. Policy makers want to convert the loans to bonds to reduce local governments’ funding costs. 

In total, eight deals had been done by early June, prompting Beijing to increase the local government bond program by another 1 trillion Yuan.

Some context here: China’s domestic bond market is estimated to be valued at around 1.2 trillion Yuan and so the new program and its implications are difficult to overstate. We think China’s domestic bond market could grow to about 12 trillion Yuan by the end of 2020 giving global investors a rapidly rising new market to tap.

The attraction for global investors is obvious. In a world where ‘the search for yield’ is a defining theme, China is a source of relatively high yield. Moreover, Chinese bonds offer diversification potential.

We estimate there is just an 18 per cent correlation between 5-year U.S. Treasuries and 5-year Chinese government bonds. In other words, bond investors wanting diversification will be looking upon China with growing interest.

As it is, foreign ownership of Chinese bonds is running at less than 3 per cent. There is a chance of adding to that modest number through more generous Qualified Foreign Institutional Investor and    Renminbi Qualified Foreign Institutional Investor quotas.

Like any relatively new market, the Chinese local government bond market requires intensive analysis. 

China is beguiling. However, that doesn’t mean that global investors should forego tough-mindedness.

Beijing does not explicitly guarantee local government bonds.  Nevertheless, they seem to be associated with defensive attributes, a conclusion investors should not automatically go along with.

The ratings of local government bonds by local credit rating agencies reflect little risk dispersion with 92 per cent of them in the AA- to AA+ range.  Only 1.9 per cent are rated A+ or below.

Those sweepingly high ratings don’t seem to capture the varied economic dynamics of China’s 30 provincial-administrative districts and 265 cities.   Analysis shows large differences in cities’ fiscal risk scores.

The major risk stems from property oversupply. Property-related risks across China are very intertwined so that’s a universal factor investors need to be mindful of. 

Other risk factors include the amount of debt already owned by each local government and the economic growth capacity of each local government.

Research by the likes of Nomura suggests that higher risks are concentrated in coastal provinces and a few western provinces, while central provinces fare better.

We believe the market will eventually discriminate between risks on a local government by local government basis – rather like investors do when assessing the Australian semi-government bond market.

Eventually, the more risky jurisdictions will attract risk premiums.

At this time, though, the Chinese local government bond market has the look of an undifferentiated mass of virtually risk-free free securities despite there being a multitude of individualised local government risks.  The securities are then afforded capital relief for the banks that buy them based on an implicit rather than explicit central government guarantee. 

That should be a note of caution. Intrepid investors prepared to do their homework can get a foot in the door of what’s going to be a market of exciting opportunities. Those who eschew forensic analysis could run into trouble.

There is also an important public policy dimension.

We think the government will be prepared to allow selective defaults (‘selective’ being the key word) to create ‘teachable moments.’ China’s current administration is, we believe, serious about introducing greater market discipline and selective defaults that fall short of systemic threats are an ideal way of making the point.

China’s leadership is aware of the countries that climbed out of poverty only to get stuck in the middle-income country trap. They’re determined that China won’t be joining those ranks.

Keep an eye on the local government bond market. It could be a bellwether. 

  

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