Traditionally, highly rated bonds from developed economies, and U.S. Treasuries more than any other, have been widely seen as safe havens for global investors. However, with increasingly unattractive yields in “safe debt”, an upstart contender has emerged in the recent months: Chinese government bonds. Until very recently, this was unthinkable, but now, with China opening up its financial markets and the much discussed “rise of the East”, global demand for Chinese government bonds is on the rise.
With the world having shrunk to “a global village”, investors have taken their search for yield and safety across new borders. Of late, more and more of them are asking the same question:
Are Chinese government bonds a safe haven, or are they still a somewhat risky and speculative investment?
To answer this question, one has to take a look at the Chinese government’s economic approach and the policy path the country has taken over the last years. Although China remains a totalitarian regime in the realm of politics, it behaves more as a free market economically, applying increasingly capitalist economic principles, arguably even more so than the West these days. Foreign capital flowing into Chinese bonds has surged in the last few years, with the Institute of International Finance estimating a total flow of $106 billion for 2020.
This can be partially explained by the fact that Beijing has made it easier to buy and sell bonds, besides adding Chinese securities to key bond indexes in 2019. The main “selling point”, however, is quite straightforward: China’s government bonds offer attractive yields, even after inflation. Compared to the US's 10-year bonds yielding 0.81%, China’s 10-year sovereign bonds yield 3.18% before inflation.
Yield on China’s Yuan-Denominated 10-Year Government Bond
Source: Refinitiv, ECR
Active investors have thus developed an interest in the higher yield and stability of the Chinese bond market, which has steadily recovered after a period of turmoil due to the coronavirus pandemic. In fact, the pandemic has only made Chinese bonds even more attractive.
What China has Done Right?
To begin with, China has built up a huge amount of debt, primarily in the corporate and local government sectors. It has US$ 3 trillion in reserves and has more savings than investments, contributing to the high creditworthiness of the country compared to other developed markets. The Bloomberg Barclays Aggregate Global Bond Index began adding Chinese bonds in April 2019, making Chinese bonds a “need-to-know” asset.
China’s household debt is also now on par with the US in terms of per capita values. Most of China’s debt is denominated in yuan, and the government has managed to restrain rates even in the face of a pandemic. While the US, Europe and Japan went all out on a money-printing binge, piling on more debt to sustain their economies, China did not raise rates. Bold investors looking out for lower interest rates and fewer currency fluctuations, therefore, have found a safe haven in China’s high-yielding, safe government bonds.
Contrary to the West’s policy attitude of “too big to fail” and “government and central banks can avoid all crises”, China’s approach to the business and credit cycle has been markedly different. They have decided to restructure the defaulting companies in the bond market, including larger ones, where the State has a stake. The idea is to “clean up the mess” in a meaningful and sustainable way, unlike the old days, when most failing entities were simply bailed out. With this healthy new approach, business cycles have been implemented to purge the system from any “zombie companies”, much like wildfires that rejuvenate and strengthen nature’s ecological balance.
No country can be complacent in making sure that excessive debt of the household doesn't create excesses and weaknesses in the financial system. Everything is interconnected.
~ Nouriel Roubini
What to Expect from China in the Coming Months?
We expect China to launch a “Bad Bank” to unload bad debt in the next few months as a way to boost this process of restructuring. We are also likely to see more defaults in the near future, which is a good thing considering that defaults and restructuring are integral components of a free market economy.
In the medium- to long-term, the entire process is bound to contribute to a healthier and stronger Chinese economy, which would offer stability, as well as instill trust in investors. Contrary to the American and European path of monetary and fiscal excess, the Chinese approach of cleaning up “the past sins of leverage” is likely to drive capital flows into Chinese debt and push equities higher.
For the moment, European investors seem to have a growing interest in China’s government bonds, largely fueled by negative interest rates at home. Recent volatility has also exposed the serious issues facing the Treasury market, sending out a clear message that their role as a safe haven may be ending sooner than expected.
Nonetheless, at this point it is still better to be cautious. That said, the Asian region, including China, continues to be on our radar and depending on relevant developments, allocations toward both Chinese debt and equity investments may enter our portfolios.