The inclusion of Chinese bonds into the Bloomberg Global Aggregate Bond Index is a recognition of the market’s stellar expansion and opening up. More importantly, the inclusion is likely to be a catalyst for even more growth and liberalization. Judging by international comparisons, there is significant room for both in the years ahead.
Scale and better access aside, there are other notable characteristics of China’s bond market:
China’s bond market is less correlated with other major markets, offering diversification potential in a global bond portfolio. The low correlation can also be useful to global investors seeking beta play in the bond market.
Chinese bonds have higher-risk adjusted returns, which could stand out in a global environment where there’s thirst for higher yields.
China's Bond Market: Big, Bigger
For foreign investors, issues such as insufficient information, lack of transparency, pricing distortions created by implicit government guarantees, and regulatory uncertainty in capital flow management are major hurdles for investing in Chinese bonds. These are not going to outweigh the gravitational pull of China, but they are reasons for caution.
The market has come a long way within a relatively short period of time:
Since the first treasury issuance in 1981 and interbank bond market opening in 1997, the bond market has grown from $4 billion in the early 1990s to more than $12 trillion today, making it the third-biggest in the world.
The market has also developed in many other dimensions, such as products and different market segments.
The market has seen substantial opening in the past 15 years, with the Qualified Foreign Institutional Investors scheme, the RMB Qualified Foreign Institutional Investors scheme, Bond Connect, and foreign investors’ access to the interbank market.
Looking ahead, international comparisons point to more room to grow. With further opening, foreign investors’ presence could increase considerably. China’s bond market, while already big in absolute terms, has some room to expand considering China’s economic scale.
Assuming that nominal GDP grows at a rate of 8.5% in 2019 and 8% thereafter and the bond market expands to 100% of GDP (from 89% now), the market could grow to $23.4 trillion in 2025 -- close to twice its size in 2017, though still behind the U.S. bond market at today’s value.
The potential for more foreign participation is significant. Foreign ownership of China’s bonds, at around 3%, is low compared with other countries. Foreign investors hold about two thirds of Australian bonds, and about 30% of U.S. bonds. For Japan, foreign ownership is at the low end among advanced economies at just over 10% of the government bond market. Among emerging markets, the share of foreign ownership is high in Indonesia (40%) and the Philippines (31%), and low in South Korea (12%) and Thailand (12%).
Looking forward, in a high-end scenario where foreign ownership reaches 27% (the average of advanced and emerging market economies), the value of Chinese bonds owned by foreign investors could grow almost 20-fold to $6.3 trillion in 2025.
Even in a low-end case of 23% foreign ownership (the average of emerging markets), the growth could be significant, with foreign holdings increasing to $5.3 trillion.
China's Bond Market Less Correlated With Global Markets
Low correlation of China’s bond market with global bond markets offers diversification potential. A Bank for International Settlements study shows that movements in China’s 10-year government bond yields are little influenced by those of U.S. Treasuries.
This is evident in our own analysis. For example, rolling correlation between changes in Chinese and U.S. 10-year Treasury yields, while rising, is much lower than that between the German and U.S. counterparts.
Higher Bond Yields: International Comparison
China’s 10-year treasury yields are higher than their counterparts in major developed markets such as the U.S., Germany and Japan.
China’s returns are also high among economies with similar credit ratings.
Written by:
Chang Shu, Bloomberg Chief Asia Economist
David Qu, Bloomberg China Economist
