China’s gradual removal of capital controls has already attracted a growing share of foreign investment, especially in the form of portfolio flows in equity and debt securities (Exhibit 1). Long-term institutional investors, such as insurance companies, have also expanded their presence in China amid rising exposures in high-growth emerging market economies, albeit with limited direct exposure in local currency (Exhibit 2). In this context, three asset classes are most attractive for foreign investors: local currency sovereign debt, highly-rated corporates and equities. These asset classes typically represent the lion’s share of insurers’ investment portfolios and also drive current exposures to China.
Exhibit 1: China: domestic financial assets held by overseas entities (CNY billion)
Exhibit 2: Eurozone: insurance company asset holdings − listed shares and debt instruments (€ billion / %)
China’s economic outlook remains favourable on account of strong policy support. China has experienced little economic scarring and has swiftly restored pre-pandemic output this year. We expect the current slowdown to peter out during the second half of next year and growth to remain solid relative to the US and Eurozone (+7.9% and +5.2% expected in 2021 and 2022, respectively; Exhibit 3). A greater fiscal impulse at the regional level funded by the issuance of special bonds should help local governments boost public investment. Additionally, financing costs should remain low due to high system-wide liquidity and window-guidance by the central bank. These policy actions, along with the temporary easing of certain regulations, are likely to steer the economy towards a soft landing.
Exhibit 3: US and Eurozone vs China − real GDP growth differential (in %)
The countries’ revised growth strategy represents a significant upside risk to the current outlook, but near-term risks are tilted to the downside. The increased regulatory oversight that has rattled markets over the past year should be viewed through the lens of an evolving long-term sustainable growth model. Rising geopolitical tensions and domestic challenges have recently weighed on investor sentiment amid uncertain virus dynamics and related policy measures. Continued government restrictions and the risk of a renewed trade conflict with the US, along with the potential for this to spread to their trading partners could have adverse confidence effects. However, over the long run, Chinese authorities’ policies under President Xi Jinping’s banner programme of promoting “common prosperity,” suggest slower but more sustainable and better distributed growth. Among other things, targets include reducing financial risks (for example, in the real estate sector), narrowing socio-economic gaps between rural and urban areas and income classes, and stepping efforts towards climate targets.
What does this mean for sovereign yields?
Low volatility, strong fundamentals and currency stability have made Chinese sovereign debt increasingly attractive for local and foreign investors alike. China is by far the largest supplier of emerging market sovereign bonds in terms of outstanding amounts, even though nearly all issues are CNY-denominated (Exhibit 4), and market access for foreigners is limited. The more open USD-denominated market for sovereign debt remains very small (even though China has recently issued more than $8 billion in foreign currency ($4 billion in October and €4 billion in November)). The controlled market environment for local currency issues has resulted in very stable price dynamics and a gradual narrowing of spreads vis-a-vis developed markets, with close fluctuations around the 3% mark, consistent with our GDP-based Chinese 10-year yield valuation model (Exhibit 5).
Exhibit 4: Emerging markets: composition of sovereign debt by currency and average coupon rate
Exhibit 5: China government bond 10-year yields (local currency)
Going forward, we expect sovereign yields to remain near current levels in the context of the Chinese government’s recent policy shift. Although long-term CNY yields’ share-pricing characteristics are similar to those of sovereign debt in advanced economies, they come with significant political and currency risks. Low overall inflation and the incipient normalisation of monetary policy in the US should lengthen the odds for a structural decline over the near term.
China’s appreciating currency
During the COVID-19 crisis, the CNY appreciated vis-à-vis most developed market currencies, resulting in positive spillover effects to China’s neighbouring countries whose currencies outperformed the currencies of other emerging markets (Exhibit 6). Historically, maintaining a stable currency has been a political priority for developing an accessible and predictable exchange rate regime as the CNY evolves into a global currency.
Exhibit 6: Foreign exchange rates (vis-à-vis $): development since 2000
Since 1994, when China unified its dual exchange rates, the currency has not suffered any large shocks that have been common in other emerging markets. On the back of China’s improving external position (Exhibit 7), our fair value analysis suggests continued structural appreciation of the CNY next year, albeit at a slower pace due to persistent headwinds to global trade and a looser domestic monetary stance.
Exhibit 7: China current account ($ billion)
However, over the last year, it has become increasingly expensive for foreign investors to hedge CNY exposure, with cross-currency swaps spreads turning positive for the first time (Exhibit 8). Overall, significant government intervention and capital controls still impede the full convertibility of the CNY, which implies structurally higher FX risk compared to other emerging markets with flexible exchange rate regimes. It is worth bearing in mind that a structural devaluation (rather than temporary depreciation) seems unlikely since it would run counter to the policy objective of globalising the CNY and Chinese exports have become less dependent on a “cheap” exchange rate.
Exhibit 8: USD-CNY cross-currency basis
Corporate credit in China
Corporate credit has been at the centre of recent market turbulence surrounding the ongoing challenges in the real estate sector. The combined effect of China’s regulatory crackdown and excessive leverage in the real estate sector and related industries has accelerated defaults in both the Chinese dollar credit market and the onshore CNY markets (Exhibit 9). However, pricing in both markets have been resilient (also due to the lower real estate weight), which can be partially explained by a stable investor base comprising largely local institutional investors. Additionally, since the onshore credit market is not fully accessible to foreign investors, local onshore investors tend to buy and hold to maturity (Exhibit 10).
Exhibit 9: China: onshore and offshore corporate bond defaults
Exhibit 10: China: onshore corporate credit market (by sector)
Notwithstanding the current uncertainty and liquidity stress affecting corporate performance in affected sectors, we are credit positive on investment grade corporates in high-growth sectors. Our investment grade corporate spread decomposition methodology shows that the weight of the People’s Bank of China (PBoC) actions in corporate spread determination has been relatively high. In this context, the expected somewhat looser monetary policy, especially in 2022, should act as a backstop for high grade credit both in the onshore and offshore markets (Exhibit 11). We expect investment grade corporate credit spreads to trade close to current levels in 2022. However, the picture looks less benign for low-rated issuers from both a tactical and strategic perspective. Wrong timing and poor asset selection could lead to substantial losses in a short period of time.
Exhibit 11: China: investment grade corporate spread decomposition (in y/y %)
Performance of equities in China
Equities have been a clear underperformer in the Chinese capital market during the COVID-19 crisis. Especially in the offshore market, equities have come under significant pressure due to correction in the real estate sector and the regulatory crackdown. However, the market correction has not been accompanied by a structural deterioration in fundamentals, making Chinese equities look fairly attractive at current valuations. Thus, price-to-earnings (P/E) ratios seem low compared to other international markets, suggesting that Chinese equities might have been oversold amid fears of further market corrections and exogenous market volatility (Exhibit 12).
Exhibit 12: China: cyclically-adjusted PE ratios
Additionally, earnings expectations have not followed the price correction path and still indicate a solid earnings recovery in both 2022 and 2023, which is confirmed by the positive long-term EPS growth forecasts. The accommodative stance of the central bank (proxied by the size of the PBOC’s balance sheet) seems to explain most of the equity performance (similar to corporate credit), while the interest and FX rates play only a minor role. Thus, the currently looser monetary stance should be beneficial for Chinese equities going forward. Despite some economic headwinds, we expect Chinese onshore equities to outperform while we remain cautious on offshore equities due to potential knock-on effects of more stringent regulations. Given the relatively high share of China in the global emerging market equity index, notably in the “offshore” segment, spillover effects are likely to be greater for Chinese equities than corporate debt.
Trade shocks in particular seem to have a damaging effect on equity market performance. Historically, negative announcements related to the trade dispute with the US have on average led to a 1% decline in the total market capitalisation of Chinese firms over a two-month period following each announcement. The risk of a renewed trade conflict with the US—along with the potential for this to spread to trading partners amid slowing Chinese imports from the region—could have adverse confidence effects and be further amplified by the financial market reaction.