A Brighter Path

2022 has been an eventful and volatile year. Despite the many challenges the market has faced and will continue to face, material progress has been made in China’s financial reform agenda.  We look forward to a brighter 2023 with optimism.  

The year 2022 has been a challenging one for markets worldwide. The year started with expectations that the pandemic was finally fading，and the world could be on a V-shaped recovery. Markets believed that the Fed would be patient，and 10y UST yielded 1.5% at end-2021. However，fast-rising inflation forced western central banks to raise interest rates aggressively despite a slowing economy. The Russia-Ukraine conflict，now in its ninth month，has added to market volatility and fueled an energy crisis in Europe. As we approach 2023，equity and bond indices are down 15-20% or more and 10y UST now stands at 3.8%.

China，being the world’s second largest economy and the largest trading nation，is not immune to these global macroeconomic and geopolitical factors. Unlike many of its peers in the US，Europe，and Emerging Markets，however，the People’s Bank of China (PBC) has not been hiking interest rates. The country’s CPI inflation has remained low and the central bank has taken an accommodative stance to support growth. Liquidity was kept abundant and market rates were guided lower. The 10-year Chinese government bond rate stood at 2.8% in mid-November，similar to the level at end-2021.

Financial Reform and Opening Up ¨C Still Committed

Despite the volatile market backdrop，the Chinese authorities have remained committed to financial reform and opening up to safeguard long-term stability and promote sustainable development.

China has further opened its financial markets to overseas investors this year. In July，it announced the launch of “Swap Connect” to facilitate offshore investors’ access to the onshore interest rate swap (IRS) market to better hedge interest rate exposures. The ETF Connect scheme also kicked off in July，allowing global investors to tap into 83 ETFs in China through accounts held in Hong Kong，and is expected to attract up to 200 billion yuan in investment within a year or two. These two new cross-border trading programs will further expand Hong Kong’s role as a connector between China and the rest of the world.

Such opening up happened after the successful launch of Southbound Bond Connect and Wealth Management Connect pilot scheme in Greater Bay Area and the approval of more quotas for QDII program last year. To be sure，the authorities allowing for more cross-border investment channels will mean more two-way capital flows and increasing policy tolerance for greater market volatility. Indeed，in light of global quantitative tightening and broad-based de-risking，there have been capital outflows from onshore markets this year，but at a magnitude smaller than during previous cycles.

Aligning with China’s goal to continue to open its capital markets，the central bank has also promoted a more flexible exchange rate. Two-way capital movements result in greater currency volatility. In October and November，RMB volatility rose to levels normally seen in “free-float” developed market currencies，with one-month implied volatility for offshore CNH trading above 10% at times. Under such circumstances，the PBC has committed to further market-oriented exchange rate reform，allowing the RMB exchange rate to play its role as an automatic stabilizer for the macro economy as well as for the balance of payments.

It is worth noting that the IMF announced in May the increase of the RMB’s weighting in its first regular review since RMB was included in the SDR basket in 2016. The enhanced standing of the RMB as a global reserve currency demonstrates international community’s recognition of China’s substantial progress in opening up its financial markets，marking another milestone for China’ efforts to internationalize its currency.

Onshore Bond Market ¨C Valuable Diversification for International Investors

From the perspective of international investors，China’s onshore bond market now ranks as the second largest in the world and features prominently in the various global bond indices. We expect the relatively resilient currency and low correlations to other fixed income assets to continue to drive foreign inflows to China fixed-income assets. Their low beta to other risky assets provides valuable portfolio diversification for international investors. With a supportive PBC promoting capital account liberalization and a resilient CFETS，we see material upside to the level of foreign participation in China’s bond market in the long term，with reserve diversification，sovereign wealth flows and private sector China mandates driving demand.

Diverging monetary policy cycle and narrowing of yield differentials this year have led to some capital outflow in of the onshore bond market. But the amount accounts for a relatively small fraction of accumulated inflows over the past decade. Global investor holdings of Chinese bonds still stood at around 3.3 trillion yuan，with foreign ownership of Chinese government bonds (CGBs) at about 9.4%，at the end of October.

That said，participation by private-sector investors has been gaining momentum in recent years，with massive inflows on the back of inclusion of Chinese bond issuance in global fixed income indices.

China’s inclusion in the Bloomberg Global Aggregate Index likely drove some US$120 billion into Chinese government and policy bank bonds between April 2019 and November 2020. The JP Morgan Government Bond Index-Emerging Markets inclusion did the same for around US$20 billion into CGBs during February to December 2020. The FTSE World Government Bond Index inclusion started in October last year，and we expect it to drive US$130 billion into CGBs between now and Q4 2024.

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