China fixed income: a safe haven asset in uncertain times?

Aggregate bonds in China and the United States are the only two major fixed-income markets to deliver positive returns this year. As of March 31, U.S. aggregate bonds were up by 2.23%, while China’s aggregate issues were up by 1.14%.¹

Over the same period, Chinese government bonds returned 0.93%, while Chinese corporate bonds have risen by 0.22%.² In local currency terms, China’s aggregate bonds were up by 3.02%, with the country’s government bonds gaining 2.81% and corporate bonds moving 2.08% higher. The renminbi (RMB) depreciated by 1.24% against the U.S. dollar (USD) during this time. 

Volatility for Chinese bonds has remained relatively low, despite extreme market conditions. Based on daily returns since the beginning of the year, the annualized standard deviation for the country’s bonds was 5.3% per year, the lowest relative to other global bond markets; similarly, correlations with other major bond markets have also been low during this period. Again, looking at year-to-date daily returns, the correlation between Chinese bonds and U.S. bonds was 0.16, and the asset class’s correlation with European bonds was 0.26.³ These levels are comparable with longer-term correlations (10 years of returns).

The People’s Bank of China’s (PBoC’s) initial response to the economic impact of the coronavirus outbreak was one of restraint. The bank made only minor adjustments to monetary policy and refrained from engaging in the more aggressive monetary stimulus that we’ve seen elsewhere, particularly in the United States where the U.S. Federal Reserve (Fed) first cut rates by 50 basis points (bps) on March 3 and then quickly followed up with a second cut of 100bps on March 15, bringing its target rate to between 0% and 0.25%.

Toward the end of March, the PBoC reduced the interest rate on seven-day repurchase agreements, from 2.4% to 2.2%, lowering the rate it charges on loans to banks by the largest amount since 2015 and signaled that there could be larger monetary policy moves ahead.

During the initial phase of its policy response to COVID-19, China acted quickly by focusing on alleviating liquidity pressure on firms, particularly small and medium-sized enterprises, and sought to provide targeted support for the regions and sectors hit hardest by the outbreak. To this end, the PBoC injected around RMB 1.3 trillion of net liquidity through open-market operations in early February⁴ and followed up with additional programs that included a reserve-requirement ratio cut of 100bps for joint-stock banks⁵ and a 10bps reduction in the medium-term lending facility rate in February.⁶ The country’s loan prime rate was also guided 10bps lower in February, but was left unchanged in March.⁷

One reason for the more muted response by Chinese authorities so far is that the reaction in domestic markets has been less acute. China’s equity markets sold off by around 10% in the last month,⁸ compared with losses of over 30% in other territories; consequently, China’s financial markets haven’t faced the same level of liquidity pressure that other developed markets have had to confront. In fact, we haven’t noticed any significant spread widening among onshore corporate bonds, and the country’s new issuance market has been functioning normally.

It’s worth noting that 10-year Chinese government bond (CGB) yields have only fallen by around 55bps—to 2.59%—since the beginning of the year, while U.S. Treasury yields declined by 107bps—to 0.84%—during the same period. Accordingly, the spreads between 10-year CGBs and U.S. Treasuries have widened by as much as 1.99%, its widest since late 2011.¹

While initial policy efforts have been focused on alleviating liquidity pressures and helping industrial activity to rebound, we believe the Chinese government will have to expand its stimulus efforts to lift demand and support growth, particularly as the global economy appears to be heading toward a sharp recession given that economic activity has effectively paused. Market commentators believe the economy experienced a sharp contraction in the first quarter of 2020 but note that a recovery in the second half of the year is likely, although real GDP growth is likely to be in the low single-digit range. In our opinion, the outlook for Chinese economic growth will be particularly challenging, as demand for its exports is expected to contract significantly in the months ahead and further stimulus will be needed to support growth. At the same time, we believe that the amount of support is unlikely to approach the level we saw in 2008.

Overall, the Chinese government is committed to maintaining a balanced approach that will support growth while ensuring financial stability; furthermore, any new measures will likely combine both monetary and fiscal initiatives. The bottom line is that the PBoC retains significant headroom to trim rates further if the need arises, but should remain prudent and patient while doing so.

The area where the impact of the pandemic will be most keenly felt in China’s economy will be in external demand. We expect China’s export sector to face downward pressure similar to what it experienced during the U.S.-China trade war, and we believe China is also likely to deliver more monetary and fiscal support to drive the economic recovery. In our view, the recent decline in oil prices will be a net positive for China, as the country imports around 70% of its oil; cheaper oil will therefore be helpful to its current account and foreign exchange reserves. Additionally, lower energy prices should help alleviate inflationary pressures and give the country more room to ease monetary policy.

We believe China’s state-owned enterprise (SOE) and local government financing vehicle (LGFV) sectors will remain instrumental in carrying out the government's fiscal stimulus, although with much less headroom compared with the last cycle in 2015, owing to the higher level of local government debt. We expect newly injected liquidity to flow primarily to higher-quality SOEs/LGFVs, while lower-rated SOE/LGFV and private enterprises (onshore AA rated or lower) could face more significant liquidity stress that will likely see default rates tick higher. 

"Compared with other major economies, the Chinese financial system should remain relatively resilient as it already went through a deleveraging process in 2017 (to 2019)."

In the Chinese property sector, developers have been negatively affected by operational disruptions from the COVID-19 outbreak since reduced cash flow from property sales raises refinancing risks. So far, the government has remained supportive of the sector and has lifted local sales restrictions in addition to providing ample onshore liquidity. However, smaller developers with limited funding channels and heavy debt maturities will be vulnerable if property sales remain sluggish—we’ve already seen a growing number of defaults by private developers since the outbreak. On the other hand, we believe major developers that are also active issuers in the offshore bond universe are well positioned to weather the current downturn, as most of them have adequate liquidity to meet debt obligations coming due in the next 12 months. The resumption of sales and construction activities for developers under our coverage appears to be on track, although we don’t expect a V-shaped recovery, as property demand remains subdued. We also think that the current situation will accelerate market consolidation, with leading developers and state-owned companies acquiring market share from smaller-scale developers that are at risk of experiencing a liquidity crunch.

The Chinese banking sector is likely to face asset quality pressures given the weaker real economy, while insurers and securities companies may suffer from capital market underperformance. Despite this, we think China’s largest banks remain well positioned, given the quality of the assets on their books and the fact that capital adequacy is at multi-year highs; in addition, they carry little exposure to LGFVs and industries suffering from overcapacity. Compared with other major economies, the Chinese financial system should remain relatively resilient as it already went through a deleveraging process in 2017 (to 2019). Crucially, the Chinese equity market has weathered the crisis better than global markets so far, and the Chinese government has a strong track record of ensuring financial stability.  

While the RMB has weakened by around 1.24% against the USD,¹ we now expect the currency to remain rangebound over the next few months. With the Fed effectively cutting rates to zero, there should be less impetus for the U.S. dollar to appreciate much more from current levels. Additionally, with China applying monetary stimulus at a more measured pace, the RMB is likely to maintain an advantage over its peers in terms of interest-rate differentials, which will support the currency despite a much softer outlook for the Chinese economy. 

The COVID-19 crisis has again illustrated the low correlation between China bonds and other global bonds; it also positions CGBs as a relative safe haven asset in these unprecedented times. In our view, the CGB market remains one of the most attractive from an absolute yield perspective and will likely maintain this yield advantage over other developed bond markets. Meanwhile, the Chinese government appears to be committed to taking a measured approach to monetary stimulus. Over the longer term, we expect that the demand for Chinese bonds will continue to grow, as the index-inclusion theme plays out and attracts more substantial fund flows, given that foreign investors remain underinvested in the asset class.

1 Bloomberg, as of March 26, 2020. Refers to performance of the Bloomberg Barclays U.S. Aggregate Bond Index and Bloomberg Barclays China Aggregate Bond Index from January 1, 2020, to March 25, 2020 in USD terms, unhedged. 2 Bloomberg, as of March 26, 2020. Refers to performance of Bloomberg Barclays China Government Index and Bloomberg Barclays China Corporate Bond Index from January 1, 2020, to March 25, 2020, in USD terms, unhedged. 3 Bloomberg, as of March 26, 2020. 4 “China to inject US$174 billion of liquidity into markets amid new coronavirus outbreak,” SCMP, February 2, 2020. 5 “China cuts medium-term rate to soften coronavirus hit to economy,” Reuters, February 16, 2020. 6 “China pumps $79 billion into economy with bank cash reserve cut,” Reuters, March 13, 2020. 7 “China keeps benchmark loan rate unchanged despite coronavirus,” SCMP, March 20, 2020. 8 Bloomberg, as of March 26, 2020. Refers to performance of the Shanghai Stock Exchange Composite Index.