China's debt levels are high and are continuing to increase, which is a concern but not immediately alarming. If the total amount of social financing is included, it would add up to about 3x the country's GDP. This is high relative to emerging market numbers but comparable to debt levels in developed markets.
"The high debt level is a conscious policy decision by the Chinese government," Arvind Rajan, managing director and head of global and macro at PGIM Fixed Income, tells The Asset. "The Chinese debts are not primarily in central government bonds. They are distributed between private debt that is intermediated by the banking system, and the municipal government debt and the local government financing vehicles that are associated with the municipal governments."
As China's debt system is heavily and tightly controlled through the major banks, the government exerts a lot of control over the level at which the borrowing takes place, the timing of the borrowing and the eventual wind down of the investment process.
The investment process can only be deleveraged gradually, Rajan points out, since China would like to avoid labour market and growth disruptions. The rate at which this process has proceeded has been disappointing to many international observers. They are expecting China to follow a similar path to a free market capitalist economy. Usually the deleveraging process that occurs in countries like the US is abrupt — it is market-mediated. Government regulations and the central bank have little control. In China, since it is a more centrally orchestrated process, the government — provided that it does the right things — can do the same thing over a longer period without the typical big swings in asset prices.
"As a result, one should not be as concerned about a high level of debt in that type of economy, such as China's — provided it pivots to a more sustainable longer-term policy and is willing to accept the slower growth that will result, which I believe it is for the most part," says Rajan. "The Chinese government is very much aware of what it is doing and why it is doing it."
PGIM, the global investment management businesses of Prudential Financial, has been involved in Chinese offshore debt and the Chinese currency for a number of years. As the rules for international participation in China's domestic bond market become standardized and as China integrates its bond market into the global market with its inclusion in the Bloomberg Barclays index starting in April 2019, "I expect to see us getting more involved in the China domestic bond market as well," adds Rajan.
PGIM is working to get its clients signed up for Bond Connect, so they can buy Chinese domestic bonds when the time comes. "I believe that there will be selective adoption of the different segments of the Chinese bond market during the course of the next few years," Rajan says.
He reckons the first segment will see the greatest interest and participation will be the Chinese government bond market. Broad participation in the debt of local government-related entities and corporates may take longer because overseas investors need to become comfortable first with not only the credits and the bottom-up analysis of these credits, but also with the appropriate level of risk premium that they will be earning for lending to those credits.
In investing in Chinese assets, PGIM looks at the same factors that it assesses when it invests anywhere else — fundamental strength of the credit, the ability to repay, transparency of governance, quality of the institutions and all the standard credit metrics and ratios, such as cash flow, leverage and liquidity.
As PGIM sees more involvement in the Chinese domestic bond market, Rajan underscores the importance of Asia in its fixed income investment decision-making process. Asia is a large part of PGIM's emerging market bond indices. PGIM Fixed Income manages over US$50 billion of emerging market bonds in local currency and hard currency combined, and Asia is a significant percentage of that.
"We are positive on the prospects of Asia," says Rajan. "Not only does the region have very good overall macro-economic prospects and good governance standards, it also boasts good credit quality compared with other emerging markets." This means that Asia offers less spread to investors compared, for example, with Latin America and other regions. Yet on a risk-adjusted basis Asia offers many good opportunities.
A big part of the Asian credit market is not really accessible to many institutional investors because it is designed to absorb the high domestic savings in the region. In China even the US dollar issuances largely target Chinese investors. Rajan explains: "You will not expect to see the same level of participation from international investors in the Asian bond market as you see in other regional markets such as Latin America that do not have a lot of US dollar surpluses and, therefore, rely much more on international investors in order to raise external funding."
