Should schemes be concerned about the Chinese debt bubble?

The two principal sources of growth are net new issuance of central government debt, which is expanding roughly in line with China’s nominal rate of growth of about 8 per cent a year, and an ongoing programme of converting non-tradeable local government loans into tradeable municipal bonds.

A bullish outlook…

China’s municipal bond market will exceed the US municipal bond markets within a decade.

There is probably no other country on Earth where sentiment can lurch so violently from fears of hard landings to concerns about overheating, seemingly with nothing in between

Based on reasonable projections for Chinese and US growth over the next few decades, China’s bonds and its currency, the Renminbi, will replace US Treasuries and the US dollar as the world’s most important benchmarks for fixed income and currency.

This is simply an inevitable consequence of China becoming two to three times larger than US by the middle of this century, because financial markets benchmark against the largest markets, as they are the most liquid.

China’s bond markets are also becoming more important to the Chinese themselves, as China will rely ever more on consumption as a driver of growth. Interest rates are the main vehicle for controlling demand, with bond markets being the primary transmission channel from policy rates to the cost of capital in the wider economy.

…but investor doubts remain

Despite the bullish outlook for its bond market, investors retain a surprising degree of scepticism about China.

There is probably no other country on Earth where sentiment can lurch so violently from fears of hard landings to concerns about overheating, seemingly with nothing in between.

However, China has maintained strong stable growth rates for a long time, in addition to moderate to low inflation rates, while demonstrating a firm commitment to structural reforms.

There are two principal explanations for the discrepancy between sentiment about and the reality of China.

Schemes can now access the asset class more easily

First, let us consider exposure. Today foreigners own fewer than 2 per cent of Chinese bonds.

This is a remarkably small percentage considering the size of the market, the strength of the economy and the Renminbi’s global reserve currency status.

Futhermore, Chinese government bonds can offer materially higher yields than other countries in the International Monetary Fund's basket of global reserve currencies. 

Access is no longer a problem, with institutional investors able to enter easily via the Qualified Foreign Institutional Investor and RMB Qualified Foreign Institutional Investor quota systems or directly into the Chinese Interbank Bond Market.

The missing part is index inclusion, but this is changing. Having been granted market-maker licences in China, the main benchmark-providing global investment banks are soon likely to include Chinese bonds in the WGBI, Bloomberg-Barclays Ag and GBI fixed income indices.

Index inclusion should result in hundreds of billions of US dollars flowing into Chinese bonds. 

Overcoming the fear of Chinese debt

The other obstacle is an almost morbid fear of Chinese debt. Yet, objectively, China does not have a debt problem.

The high domestic credit to GDP ratio of nearly 300 per cent scares many, because this is high by emerging market standards, albeit not unusual by developed market standards.

However, Chinese credit is financed by an extremely large deposit base of 200 per cent of GDP, which means Chinese banks are far less leveraged than Western ones.

Besides, most Chinese credit finances infrastructure, which promises better returns than the consumer loans extended by much more leveraged Western banks.

Infrastructure loans may be less liquid, which can occasionally result in liquidity shortages, but this should not be confused with systemic risk.

UK and other pension funds should take a fresh look at Chinese bonds. The gulf between current exposures and likely future allocations should be bridged as early as possible.

As more investors enter, yields will fall and liquidity will improve. Early movers will harvest these benefits.

Jan Dehn is global head of research at emerging markets investment manager Ashmore Group