China calling: The rise of Chinese bond markets

(Introduction) Our fixed income experts review China’s market policy, economic reforms and forward-looking innovations. We examine sovereign bonds, commercial banks, currency and corporates, and offer views to help inform your decision making.

    Stephen Dover, CFA

    Stephen Dover, CFA Chief Market Strategist, Head of Franklin Templeton Investment Institute, Franklin Templeton

    INTRODUCTION

    In a year that saw record foreign inflows to Chinese bonds, 2020 was also a reflective year for me personally, having watched China’s economy grow over the last 40 years. I first traveled to China in 1982 as a student studying Chinese economics and history. Years later, I returned to help launch a local joint venture—Franklin Templeton Sealand Fund Management Co., Ltd. (FT Sealand), which was established in 2004. In the following five chapters from our fixed income managers, we examine China’s sovereign bonds, commercial banks, currency and corporates (state-owned and private). Here are a few of our key takeaways:

    • Within a global framework, Brandywine Global Investment Management believes China sovereigns fit better directly alongside traditionally perceived safe-haven bonds like US Treasuries, rather than inside an emerging market debt allocation. China bond analysis, however, starts with a clear recognition that China’s capital markets aren’t purely “market driven.”

    • China’s economy is an evolving hybrid of top-down statecraft guided by policymakers and market-based capital allocations. In Chapter 2, Western Asset discusses how China’s six largest commercial banks are helping China achieve high-quality growth by putting private companies on a more level playing field with state-owned enterprises (SOEs).

    • One of China’s biggest strategic advantages is its ability to rapidly scale and deploy technologies to modernize its financial system and increase corporate competitiveness. Recent examples include the digitalization of China’s renminbi (RMB), discussed by Templeton Global Macro in Chapter 3, and high-tech industries like organic light-emitting diode (OLED) displays, an area where state resources can turn Chinese SOEs into global leaders, as discussed by FT Sealand in Chapter 4.

    • Of course, China’s top-down approach to boosting quality growth also produces regulatory headwinds that impact bottom-up credit analysis. In Chapter 5, Franklin Templeton Fixed Income reviews a flurry of rules from recent years meant to de-risk China’s real estate sector; this alters the credit profiles of private property developers, who outnumber SOEs in this sector.

    It’s worth emphasizing that integrating China’s top-down policies into credit analysis is hard work. New macroeconomic rules don’t arrive in easy-to-read blueprints. Instead, policies written in Mandarin arrive in a matrix of interlocking documents from different Chinese agencies, impacting the broad bond market and individual corporates.

    Knowing how China’s policymakers think

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    Select Chapters

    In a tumultuous year for global bonds, China offered investors a bright alternative in 2020. With its resilient economy, sovereign bond yields reaching 3.3%1 and a rising currency,2 China’s sovereign bonds had one of the world’s highest total returns in 2020. Becoming a dominant player on the global stage has been one of the Chinese government’s chief goals this century. Back in 2000, China’s bond market trailed far behind developed countries like Japan and the United States by size.3 Today, the scale of China’s bond market is second only to the US bond market.

    Franklin Templeton was an early investor in Chinese equities, researching companies as early as 1987. While foreign investment into China has historically been on the equity side, our independent investment managers have been developing their expertise and exposure to Chinese bonds for many years. To make the case for placing Chinese bonds inside global portfolios, each of the following chapters explain how our investment managers integrate China’s macroeconomic innerworkings into sovereign, quasi-sovereign and currency analysis along with bottom-up credit analysis across corporate SOEs and private enterprises. Navigating Chinese bonds requires unpacking past reforms following the global financial crisis (GFC) and a raft of new policymaker guidelines—all aiming to achieve China’s goal of becoming the world’s largest economy by 2035.

    China’s economic reforms

    One standout feature of China’s economy in 2020 was its disciplined use of stimulus to recover from the economic tailspin of the COVID-19 pandemic. Most of the world’s major central banks dropped interest rates and increased quantitative easing, while many governments dramatically increased fiscal spending and their already gargantuan deficits. In contrast, China’s quick containment of COVID-19 meant it could resume its previous glidepath of deleveraging. As Brandywine Global explores in Chapter 1, China’s disciplined approach to stimulus coupled with relatively high bond yields attracted record foreign inflows into China’s government bonds. Brandywine Global makes a compelling case for why China’s sovereigns now belong inside a developed market bond allocation rather than lumped with emerging market peers.

    Since the start of Xi Jinping’s presidency in 2013, China aimed to improve productivity growth by injecting more market-based discipline into capital and credit allocations. In Chapter 2, our credit team from Western Asset explains why offshore bond exposure to China’s largest state-owned commercial banks offers a levered play on China’s sovereigns. China’s sprawling banking system plays a key role in China’s pivot away from money-losing, debt-laden “zombie” SOEs, and increasing support for private enterprise. To grasp how far China’s banks have evolved means examining the role they played in pumping credit (much of it wasteful) into China’s economy after the GFC. Today, China’s policymakers are telling banks to reorient loans toward privately owned companies whose organic (not debt-driven) innovations can generate high-quality growth. For China’s six largest banks, these risks are manageable given their ample exposure to systemically important SOEs.

    China’s forward-looking innovations

    Across the investment teams featured in this piece, all five agree one of China’s biggest strategic advantages is its ability to rapidly scale and deploy technologies. For our Templeton Global Macro team, that technological edge is manifest in the upcoming launch of China’s new digital currency, outlined in Chapter 3. Under development since 2014, the digitalization of China’s renminbi will likely accelerate the internationalization of China’s currency.

    In Chapter 4, the team at FT Sealand—our Shanghai-based joint venture—explains how national policies like “Made in China 2025” helped jumpstart China’s push into OLED displays used in premium mobile phones. FT Sealand explains why a major part of its credit analysis involves understanding how SOEs fit inside China’s evolving industrial policies. Turning to privately owned enterprises in Chapter 5, our Franklin Templeton Fixed Income team examines China’s drive to de-risk the overheated real estate sector. New regulations are forcing property developers to shed assets and boost near-term cash flows, in some cases by selling new homes at fire-sale prices. Looking ahead to 2035, China’s policymakers are guiding property developers to build giant “city clusters,” each with capacity to house 100 million urban residents.

    China bond categories

    To help orient readers to our five fixed income chapters, Exhibit 1 illustrates how the bulk of last year’s foreign inflows went into ostensibly “risk-free” Chinese government and policy bank bonds.

    RECORD CHINA BOND INFLOWS Exhibit 1: 2020 foreign inflows into China’s onshore RMB bonds

    Source: Institute of International Finance, March 2021.

    For our chapters on bonds with incrementally higher credit risks, such as commercial banks and corporates (both state-owned and private), we note that except for FT Sealand, most of our bond exposures in these categories are through China’s offshore US-dollar bond market.

    Contributors

    ENDNOTES

    1. Source: Macrobond, 10-year maturity.

    2. Source: Macrobond, People’s Bank of China.

    3. Source: “China Corporate Bond Market Blue Book,” Fitch Ratings October 2019.

    WHAT ARE THE RISKS?

    All investments involve risks, including possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. Bond prices generally move in the opposite direction of interest rates. Thus, as prices of bonds in an investment portfolio adjust to a rise in interest rates, the value of the portfolio may decline. Investments in lower-rated bonds include higher risk of default and loss of principal. Changes in the credit rating of a bond, or in the credit rating or financial strength of a bond’s issuer, insurer or guarantor, may affect the bond’s value. Bonds with lower ratings and higher credit risk (risk of default) typically offer higher interest rates to compensate investors for the higher risk associated with the investment. High yields reflect the higher credit risks associated with certain lower-rated securities held in the portfolio.

    Special risks are associated with foreign investing, including currency fluctuations, economic instability and political developments; investments in emerging markets involve heightened risks related to the same factors. To the extent a portfolio focuses on particular countries, regions, industries, sectors or types of investment from time to time, it may be subject to greater risks of adverse developments in such areas of focus than a portfolio that invests in a wider variety of countries, regions, industries, sectors or investments. Investments in emerging market countries involve heightened risks related to the same factors, in addition to those associated with these markets’ smaller size, lesser liquidity and lack of established legal, political, business and social frameworks to support securities markets. Such investments could experience significant price volatility in any given year. Sovereign debt securities are subject to various risks in addition to those relating to debt securities and foreign securities generally, including, but not limited to, the risk that a governmental entity may be unwilling or unable to pay interest and repay principal on its sovereign debt. China may be subject to considerable degrees of economic, political and social instability. Investments in securities of Chinese issuers involve risks that are specific to China, including certain legal, regulatory, political and economic risks. Real estate securities involve special risks, such as declines in the value of real estate and increased susceptibility to adverse economic or regulatory developments affecting the sector. The technology industry can be significantly affected by obsolescence of existing technology, short product cycles, falling prices and profits, competition from new market entrants as well as general economic conditions. Any companies and/or case studies referenced herein are used solely for illustrative purposes; any investment may or may not be currently held by any portfolio advised by Franklin Templeton. The information provided is not a recommendation or individual investment advice for any particular security, strategy, or investment product and is not an indication of the trading intent of any Franklin Templeton managed portfolio. Past performance does not guarantee future results.