Time to ditch China’s EM tag with international bond investors

If China can’t make it into the coveted high-grade bracket, should it be given its own ‘in-waiting’ classification away from emerging markets? Arguably yes.

Viewpoint

Should China be deemed an emerging market from an international bond market perspective? It’s a question international bond investors, sell-side underwriters, and service providers have been asking for some time.

If China can’t make it into the coveted high-grade bracket, should it be given its own ‘in-waiting’ classification away from EM? Arguably yes.

From an international primary bond market standpoint, it’s a question that could be increasingly important as the era of rampant yield tourism spawned by ZIRP/NIRP starts to recede and the over-bought spread between investment-grade and high-yield, emerging markets and other high-Beta and event-risk markets is restored to its natural basis.

In my previous column (European companies: beware the irrational China premium), I suggested that European companies that gain Chinese majority or even significant minority ownership will be forced to pay up to tap international bond investors. That’s not because of credit issues per se but because of the different buyer bucket companies find themselves in when they look to tap the bond market when they’re China or EM-related.

London-based underwriting banks complain that it can be tough to gain traction with the huge pool of high-grade bond buyers when it comes to China despite China’s status as the world’s second largest economy. They say they are often rebuffed when trying to sell paper into high-grade accounts and referred to the EM desk, which views pricing through a different lens.

China sits on the EM side of the fence even though it has solid investment-grade sovereign ratings. For a mega-economy that is starting to build a track record of technological and industrial innovation; which runs a decent current account surplus; sits on over US$3 trillion in foreign exchange reserves; and is working through a programme of financial market reforms; that looks odd.

A key issue curbing China’s offshore bond market status is that index providers apply arguably out-dated and not immediately relevant World Bank and IMF taxonomies. The Bloomberg Barclays country classification, for example, automatically classifies countries tagged as low/middle income by the World Bank or as non-advanced countries by the IMF as emerging markets. Its EM classification also includes countries ‘viewed by bond investors as emerging markets’; an unhelpful and rather pointless and circular addendum for an otherwise rules-based taxonomy.

To get into MSCI’s developed market bucket, countries have to maintain GNI per capita 25% above World Bank Atlas method thresholds for three consecutive years. S&P Dow Jones Indices uses the IMF World Economic Outlook classification, which currently tags China as an emerging/developing economy.

Under the World Bank Atlas method, economies with a per capita GNI of between US$3,896 and US$12,055 are classed as upper middle-income countries. China currently sits in the middle of the range but will be comfortably exceed it by 2021, according to IMF estimates. It’s worth noting, incidentally, that on a PPP basis, China’s per capita income will be above US$18,000 this year, rising to US$24,321 by 2022.

The question that immediately presents itself is: what does the per capita income of a country like China have to do with the spreads its borrowers pay in the bond market? Serious question. Sure it’s a short-hand metric that infers a lot of economic development and potential event-risk issues. But how relevant is it? And how relevant for China?

Investability is a classification issue. On the currency side, there have been some capital account liberalisations (though the currency is likely to remain a managed float for some considerable time).

And with the financial market reforms China has unleashed in recent years and which are still in play – like doing away with foreign shareholder restrictions on banks, wealth and asset managers and securities dealers; expanding the scope of what foreign banks can do; opening up the insurance market etc – those concerns will presumably have receded. And of course the Northbound trading leg of Bond Connect, offering foreign investors access to the onshore China Interbank Bond Market, kicked off a little over a year ago.

The data looks promising: average daily volumes in June were more than double the volumes seen in Q1; June trading volumes were almost twice those of May and there were 356 approved overseas institutional investors at the end of June (albeit many of them units of Chinese financial institutions). Foreign holdings were up 70% to end-May since the scheme’s launch. 

China has come a long way in a short time. While it maintains certain structural issues in its economy that are redolent of emerging markets, it has transcended many market access market and other investability issues. It’s only a matter of time before bond index providers upgrade their inclusion criteria.

To that point, Bloomberg has said it will add RMB-denominated government and policy bank securities to the Barclays Global Aggregate Index in 2019 if the PBoC and MoF implement planned operational enhancements. Assuming that happens, local currency Chinese bonds will become the index’s fourth largest currency component (after US dollar, euro and yen).

International bond investors, whether in Europe or the US, should take note. Time to re-appraise the China bond pricing paradigm?