China's Global Bond Index inclusion could prove watershed moment: S&P

May 10, 2019

SINGAPORE- Foreign investors' holdings of Chinese domestic bonds could rise to $500 billion in the next one to two years, raising China's exposure to the global financial cycle, according to a report published today by ratings agency Standard and Poors. The report says China's bond market will also increasingly affect financial conditions across Asia-Pacific.

"Foreign investors were almost completely absent from China a decade ago and now hold about 2% of bonds outstanding," said Shaun Roache, Asia-Pacific Chief Economist at S&P Global Ratings.

"This is still low by major bond market standards, but is rising, and could reach 4% in the next year or two."

China's inclusion into a global index may prove an inflexion point, the report says.

On April 1, 2019, the Bloomberg Barclays Global Aggregate Index became the first major global fixed-income benchmark to include a wedge of China's vast onshore market. This index is tracked by an estimated $2.5 trillion of assets.

If China's weight rises to 6% by 2021, as envisaged, this would imply further inflows of $150 billion. Other index providers are likely to follow suit, the report says.

"As foreigners enter, China may gradually lift controls on bond outflows -- the ease with which Chinese investors can acquire foreign bonds.

"Both foreign and domestic investors will then compare yields on Chinese bonds to global benchmarks such as U.S. Treasuries and German bunds. The Chinese market may be used as a safe haven during times of higher global uncertainty or, if real yields remain low, used to fund carry trades."

The report says bigger bond market flows, in both directions, will increase China's exposure to the global financial cycle and strengthen China's influence on financial conditions across the region.

"Small ripples across China's bond yields could cause large waves in the region's other bond and currency markets."

To date, while the renminbi has become important for the region's financial markets, China's bond market has not been a driver of regional financial conditions, the report says.

Indeed, S&P Global's analysis shows that Asia-Pacific bond yields are driven mostly by U.S. Treasuries and--for emerging markets such as Indonesia and the Philippines -- global risk sentiment (as reflected in the S&P500 VIX). However, this is set to change."

"Forward-looking financial decision-makers will need to update their thinking to give China a more influential role in financial conditions across Asia-Pacific  - including interest rates, bond yields, and exchange rates," said Roache.

Event studies that carefully analyse the reaction of asset prices to developments in China during short windows of time should be part of the tool kit when assessing how China's bond market influence is growing, the report says.

"Waiting for correlations to shift will take time, perhaps a few years of data. In the meantime, the world will already have changed." (ATI)..