China’s Ray of Light on Fixed Income
During 2020, advanced economies were impacted by several waves of the COVID-19 pandemic, forcing them to introduce very restrictive and economically costly lockdowns. However, China managed the spread of the virus more successfully and, as a result, fared materially better than most other economies.
Overall Chinese growth momentum has picked up since the second half of 2020, but importantly, the composition of this growth has improved. For example, COVID-product focused exports, real estate and infrastructure, which were key drivers of the upturn in fixed asset investments and overall GDP growth early on in the recovery, are now handing over the baton to a broad-based pickup in manufacturing investment. Also, retail sales are improving in real terms. We believe these are good signs. Notwithstanding a soft patch in the January 2021 PMIs, we expect consumption to catch up to the burgeoning trend in the production side of the economy, mainly propelled by China’s rising exports.
The external sector has been in the spotlight of the Chinese economy. Exports have been significantly boosted by robust global demand for medical equipment and electronics, as well as by global government stimulus, as shown in the graph below. The meaningful increase in exports has triggered a large rebound in the current account surplus, and a notable acceleration in the accumulation of currency reserves during the last couple of months, even after adjusting for improvements due to valuation effects. It appears progressively harder for authorities to engineer further capital outflows (with negative rates in most of the G10 countries) to keep balance-of-payment surpluses in check. This dynamic should fuel further Chinese yuan appreciation over coming quarters, especially in the event the US dollar continues to experience headwinds against other developed market currencies.
China: Monthly Trade Balance Hit a Record High in December 2020
As of January 31, 2021. Source: Mellon, Macrobond, China Customs Statistics Information Center (CCS).
The Policy Play
We believe the net export-led upturn in China’s economy is neutral for monetary policy. To be sure, the People’s Bank of China will remain focused on ‘normalizing’ policy and keeping a lid on financial stability risks by squelching property price appreciation, gradually lowering implicit sovereign guarantees in the state-owned enterprise sector and curtailing excessive margin trading in the equity market. This normalization, however, does not entail a series of further increases in interest rates, but rather slowing down credit growth, withdrawing some of the fiscal impulse, and scaling back regulatory forbearance taken at the time of the COVID crisis in early 2020. At this stage, interest rate hikes are not necessary, as inflation is nowhere to be seen and inflation expectations are well anchored. Larger rate hikes could even be counterproductive and set back a nascent broadening of the economic recovery or even raise speculative capital inflows by a much larger extent. This would make it more difficult to recycle the current account surplus and place even more appreciating pressure on the Chinese yuan.
The Yield Advantage
In the last few weeks, and even at the end of 2020, the local rates market experienced some pressure as expectations of policy normalization made investors nervous, triggering outflows from onshore bond funds. We believe short-term market rates overreacted due to these concerns, and the bulk of the pressure now appears behind us. Authorities have recently indicated their intension to chastise state-owned enterprises and curb excessively leveraged trading in the country’s equity and bond markets. But timely infusions of money market liquidity have stabilized sentiment and rates volatility. Net bond issuance should be another positive technical for the local bond market in coming quarters. We expect the fiscal deficit to compress in 2021 and net issuance to go down by around two percent of GDP. In particular, the reductions should come from fewer super-long-dated bonds as the local governments have been asked to limit issuance in the 10-year+ tenor to 30% of total issuance, down from around 50% in 2020. Meanwhile, onshore lifers’ demand for 10-year+ paper is likely to remain unchanged in 2021 versus 2020, and long-dated yields are poised to do well as shown below.
Government Benchmarks, 10-Year Yields: G3 Economies and China
As of January 31, 2021. Source: Mellon, Macrobond.
We think there is attractive value in the Chinese local currency bond market. A solid net exports position should sustain a strengthening trend in the currency, which, alongside high real rates, should keep a lid on inflation and stabilize inflation expectations. Well managed liquidity tensions and the abatement of net issuance in 2021 should provide additional support to the Chinese Government Bond market. Even in comparison to other G3 or G7 countries, the Chinese fixed income story stands out. China’s healthy positive real interest rates appear exceptional in a world where all developed economies (and even some emerging economies) offer deeply negative real interest rates.
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