Will the FTSE Russell Index inclusion and improvements in renminbi execution boost foreign inflows?

Unveiling What’s Next for China’s Bond Market

Shen Li Head of Global Markets China & Head of Indirect FX

and Street FX, Asia Pacific, State Street

Foreign holdings of China’s bonds ended 2020 at ¥3.25 trillion, having increased by a record ¥1.15 trillion during the year.1 The inclusion of China’s sovereign bonds in the Financial Times Stock Exchange (FTSE) Russell World Government Bond Index (WGBI), to be rolled out from October, should add fresh impetus to foreign inflows.

1 https://www.chinabond.com.cn/cb/cn/yjfx/zzfx/yb/20210107/156271799.shtml

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This inclusion is a major step toward

full representation in the global bond

market. It is likely to justify additional

allocations from foreign money

managers and asset owners with

roughly US$2.5 trillion in assets under

management that follow the WGBI.

However, FTSE Russell’s decision to build up to

the total weighting of 5.25 percent over a period

of three years rather than one year, as originally

intended, signals that the index provider – and

the investors it consulted with – still have

some reservations about the regulatory and

operational effectiveness of the market.

Fresh Impetus For Foreign Ownership?

FTSE Russell is now the third global index

provider to incorporate Chinese government

bonds. The Bloomberg Barclays Global

Aggregate Index was the first to incorporate

onshore Chinese yuan renminbi (CNY) bonds

in April 2019 and took 20 months to build up to

a 7 percent weighting. The JPMorgan Government

Bond Index-Emerging Markets (GBI-EM) inclusion

followed in February 2020, with a 10-month

timeframe to reach China’s 10 percent weighting.

These forerunners have been a factor in the

continued rise in foreign ownership of Chinese

government bonds since 2019 (see Figure 1).

Though at around 10 percent at year-end

2020,2 foreign ownership is still only about

a third of the 30 percent foreign holdings of

United States Treasuries.

2 https://content.ftserussell.com/sites/default/files/ftse_russell_china_bond_report_mar_2021_final.pdf

Figure 1: Foreign holdings of Chinese bonds (December 2017 – December 2020) (AANA)

2000

1600

1200

800

400

0

3.5

3.0

2.5

2.0

1.5

1.0

China Government Bonds China Policy Bank Bonds NCDs All (RHS)

12/2017 6/2018 12/2018 6/2019 12/2019 6/2020 12/2020

CNY Billions CNY Trillions

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With primarily passive investors following

the benchmark, the FTSE Russell inclusion

may change this trend and it is likely to steadily

increase their weighting of China’s bonds to the

required level. For example, Japan’s institutional

investors are known to follow WGBI, including

the likes of life insurers and large pension funds.

If passive investors simply follow the

recommended weighting, it implies a total inflow

of around US$150 billion. Also, if central banks

increase their reserve holdings to reflect the

yuan’s 10.9 percent weighting in Special Drawing

Rights (SDR), it would add a further inflow of

US$311 billion.3 A report from the Institute of

International Finance predicts that should global

yuan reserves reach 3 percent of China’s gross

domestic product (GDP) over the next 10 years,

it would imply annual inflow of more than

US$400 billion.4

China also has fundamentals in its favour, with

most of the world’s major economies still mired

in zero interest rates and negative short-term

government bond yields. China’s 10-year yield

is almost double that of US Treasuries and still

offers an attractive premium even after foreign

exchange (FX) hedging costs are stripped out.

Combined with the relatively shorter duration

of its market indexes, China’s sovereign credit

rating of A+ is in clear contrast with G7 bonds,

which helps improve the risk-reward ratio

that is paramount to institutional investors.

To date, China’s bond market has shown a low

correlation to global fixed-income markets,

adding another benefit of diversity to an already

attractive market.

Addressing Market Obstacles

Difficulties with FX hedging have continued to be

a significant drawback for investors as it has an

important bearing on the net yield. These issues

ranged from operational, with the separate on

and offshore currencies having the same

International Organization for Standardization

(ISO) currency code, to executional, with a lack

of pricing counterparties and transparency.

To help resolve the issue, the Hong Kong

Monetary Authority enhanced the flexibility

of yuan transactions in March 2021 by allowing

asset managers of up to three banks to conduct

competitive FX pricing. The greater liquidity and

transparency from the ability to compare prices

brings the yuan up to a global standard and is an

important improvement for foreign institutional

investors that have to show provable best

execution for trades.

The greater liquidity and transparency from the ability to compare prices brings the yuan up to a global standard and is an important improvement for foreign institutional investors that have to show provable best execution for trades.

3 https://www.ftserussell.com/blogs/chinas-wgbi-entry-will-confirm-its-arrival-global-market4 https://www.scmp.com/economy/china-economy/article/3141932/chinas-yuan-bond-market-could-attract- us400-billion-year-over

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Banks that have China foreign exchange trade

system (CFETS) overseas bank membership and

FX Settlement Bank status will be best positioned

to offer ample yuan liquidity in spot, forward and

swap markets that clients need for their trading

and hedging requirements.

However, investors are still only allowed to

conduct currency and hedging transactions

as long as they are supported by genuine and

reasonable bond transactions, with a tolerance

of 15 percent.5 This restriction – aimed at curbing

speculative activity – may still prove a hurdle for

those active managers that want to make short-

term profits from a bond issue by oversubscribing

for their desired amount, and therefore, need

excess cash in advance. Whereas for more

cost-conscious passive funds, competitive pricing

removes their biggest impediment.

5 https://www.hkma.gov.hk/media/eng/doc/key-information/guidelines-and-circular/2021/20210305e1a1.pdf

Figure 2: How State Street is helping clients to navigate market challenges

• Liquidity challenges for

FX hedging

• State Street has CFETS overseas

participant bank membership

and FX Settlement Bank status

• Offers 3rd party CNY FX

for funds custodied elsewhere.

This enables clients to settle

and hedge all their managed

portfolios.

• With an increased pool of

liquidity, investors are able

to more closely meet their

fiduciary obligations to help

achieve best execution and

see more competitive pricing

• Operational inefficiencies

and price opaqueness around

FX hedging

• Offers clients CNY liquidity in

spot, forward and swaps from

the deep CFETS liquidity pool;

and both CNH and CNY securities

and FX denominated services for

individual funds concurrently

• Capability to distinguish

between CNY and CNH assists

investors with selecting a more

economical funding currency -

hedging is often cheaper in CNY

than CNH especially in times of

increased volatility.

• Administrative challenge created

by CNY and CNH having the same

ISO currency code

• State Street’s automated

solution uses a segregated

securities account for each

funding channel, and uses the

securities account number as

a unique identifier for tracking

funding and hedging currency

• Helping to significantly reduce

the administrative burden on

investors seeking to hedge in

the CNY and CNH markets

Challenge to market participation

State Street solution/support

Outcome for clients

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International Bond Indices Send

a Clear Message to Global Investors

International bond indices are sending

a clear message to investors worldwide that

they believe China is ready to become a full-

fledged member of the world’s sovereign bond

community. Yet global fund managers have

remained circumspect, even as government

reforms steadily lower operational hurdles and

open up China’s bond market to foreign players.

The arrival of the FTSE Russell Index, combined

with a significant step forward in FX execution

and competitiveness, may finally be the invitation

the rest of the world accepts.

2021The Hong Kong Monetary Authority enhanced the flexibility of Yuan transactions by allowing asset managers up to three banks to conduct competitive FX pricing.

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For more information, please contact:

Shen Li

Head of Global Markets China & Head of Indirect FX

and Street FX, Asia Pacific, State Street

+852 3667 7019

sli4@statestreet.com