A large index provider's decision to exclude the Asian superpower has put the focus on a deadlock in expectations
China’s master plan to attract foreign investment through inclusion in major indexes has hit a snag.
In recent years, the country opened up its main interbank bond market to overseas investors, letting foreign firms buy bonds through a Hong Kong trading link called Bond Connect, reported The Wall Street Journal. Efforts such as that have allowed JPMorgan Chase and Bloomberg to add Chinese bonds to some of their widely followed gauges.
“Index inclusions have helped drive foreign interest in Chinese bonds, even as the trade war with the U.S. stretches into its second year and growth has slowed to its lowest in decades,” the Journal reported. Citing figures from the People’s Bank of China, it reported that foreign ownership of Chinese bonds topped US$280 billion, or 2 trillion yuan, in June.
However, FTSE Russell has held off on adding government securities issued by a country to its key benchmarks. The index provider praised China’s progress in opening its bond markets, particularly through efforts such as ending quotas under the Qualified Foreign Institutional Investor program.
But it said it would not upgrade China’s market accessibility rating, a determinant of index inclusion, until investors saw “improvements to secondary market liquidity, and increased flexibility in [foreign-exchange] execution and the settlement of transactions.”
China will have to wait another year for FTSE Russell’s next review. Had the country been granted an upgrade this time, the FTSE World Government Bond Index — used by investment vehicles such as Franklin Templeton’s US$33-billion Templeton Global Bond Fund — would have been able to make space for Chinese debt securities.
As the Journal noted, the decision puts both parties at an impasse. With more potential foreign investment, Beijing was looking forward to a more disciplined bond market, which would have improved liquidity. But index providers such as FTSE Russell want evidence of that improvement before they wade too far into China’s bond pool.
With a value of roughly US$13 trillion, the country’s bond market is roughly double the size of its stock market, and has been a keystone component in efforts to shift to more market-driven financing. Introducing long-term, passive global fixed-income investors with benchmark-hugging tendencies would create an invaluable segment of participants who won’t pull out at a moment’s notice.
“But FTSE is right to highlight liquidity concerns: Trading volumes in the market are tied closely to interbank interest rates because many purchases are financed with short-term borrowing,” the Journal noted. Rising rates lead to tumbling trading volumes, and a fall in rates can lead volumes to surge by up to 200% year-on-year, figures from the International Monetary Fund suggest.
In 2017, repo borrowing volumes heated up to around 15 times the daily average trading volumes of government bonds, more than twice the peak seen in the U.S. during September 2008 in the throes of the financial crisis.
Analysts from HSBC have estimated that inclusion in the FTSE index would have created US$150 billion in inflows into China — similar to the potential from the Bloomberg decision, and much larger than the US$20 billion estimated from JP Morgan.
Investors in the FTSE benchmark, meanwhile, would have gotten access to a bond market much less correlated with the actions of the Federal Reserve than other emerging markets. In recent years, Chinese government bonds have acted more like those from advanced markets, while offering far higher yields.