Introduction
Countless articles have been written in the past 10 years predicting (or warning) of China’s imminent financial demise, with the number of articles accelerating in recent years amid China’s debt build-up in the post Global Financial Crisis period. Investing on the basis of a “China collapse” view of the world would likely have resulted in more risk-averse portfolios in the emerging debt space and, hence, lower returns in recent years. Our investment process, which is heavily skewed toward finding underpriced securities (bottom-up) rather than making global macro calls, or even country calls, for the most part exempts us from having to take a view on topics such as if and when China is going to collapse. That being said, China’s presence in our asset class is increasing and, as alpha-focused investors, we are aware of our direct and indirect China exposures and the relative value of China exposures. This paper provides our readers with a glimpse into how we view China’s sovereign, quasi-sovereign, rates, and FX exposures.
China’s Increasing Presence in the Asset Class
China’s well-documented debt build-up has had a significant impact on the emerging debt asset class. Since the Global Financial Crisis in 2008, China has done the world a big favor by boosting growth through a debt-financed investment spending binge. The aggregate debt-to-GDP ratio of “China Inc.” (corporates, households, governments, and banks) has doubled and now stands at about 258% of GDP.2 During this period, China contributed over half (57%) of the world’s nominal growth in GDP, measured in US dollars.3 In doing so, it sucked in commodities from all corners of the earth.
As seen in Exhibit 1, more than half of the 100% of GDP in incremental debt has been incurred by the corporate and state-owned enterprise (SOE) sector. The rest was split between government and households to levels that are, by international standards, not very alarming. The increase in SOE and corporate debt has had a dramatic impact on certain emerging debt benchmarks. Exhibit 2 shows China’s weight in the EMBIG benchmark of dollar-denominated sovereign and quasi-sovereign debt. Two things are notable. First, in the past five years China has gone from relative insignificance in this benchmark (with a weighting akin to countries like Lebanon, Kazakhstan, Panama, and Lithuania) to a weighting of more than 8% as of June 2017, second only to Mexico. Second, the entire China component of the benchmark is comprised of quasi-sovereign issuers that are, by the criteria of index inclusion, 100% owned by the Chinese government (more on this later).
In terms of local debt markets, China is currently unrepresented (please see “The What-Why-When-How Guide to Emerging Country Debt: 2017 Edition” for more detailed discussion), but this is likely to change in the next 12 to 18 months. The authorities are taking aggressive steps to open the onshore debt markets to foreign investors, which is a necessary condition to meet liquidity and transparency requirements for inclusion in, for example, J.P. Morgan’s GBI-EMGD local debt benchmark.4 China’s domestic government bond market is the third largest in the world, at about $1.8 trillion, which dwarfs the entire market capitalization of the GBI-EMGD, at $1.2 trillion. It follows, then, that China’s weighting will eventually be at the 10% cap. Exhibit 3 shows the current weightings of the benchmark and our estimate of the pro-forma weightings after China is fully incorporated into the index.5 Weightings of Brazil and Mexico, which are also at the cap, are unlikely to change, but several countries could see their weights drop by a percentage point or more.
Possible future inclusion in the local debt benchmark is consistent with China’s growing role in the world economy. China’s impact on trade flows and supply chains has skyrocketed since it joined the World Trade Organization in 2001. Recent steps have paved the way for a more important role in global capital markets.6 China has become the largest bilateral lender to many emerging countries, and this status is likely to grow as a result of the Belt and Road Initiative, and various multinational development banks in which China is taking a leadership role. The CNY has gained inclusion in the SDR basket of currencies, and gained inclusion of its onshore equity markets to the MSCI indices. China’s future inclusion in the local debt benchmark is likely to affect the benchmark more than China’s domestic capital markets. Assuming a 10% cap on China’s weighting, this would correspond to about $120 billion equivalent of Chinese bonds being included in the benchmark. While this would be 10% of the benchmark, it would represent only about 7% of China’s domestic government bond market of $1.8 trillion. This is unlikely to have much impact on China’s own financial markets, but it is consistent with the creeping importance of China in the world. This is also why China is lobbying to be included in the much larger Bloomberg Barclay’s Aggregate Index (formerly Lehman Aggregate) and the Citibank World Government Bond Index. These are potentially more impactful for China. Whereas the GBI-EMGD has only an estimated $200 billion in benchmarked assets under management, the other two larger benchmarks have an estimated $4 trillion in AUM.
Finally, Exhibit 4 shows the staggering increase in the Chinese weighting in the CEMBI index of emerging corporate bonds, which has gone from relative obscurity in 2009 to more than 20% currently. The next largest country is Brazil, at 12.7%. This chart is meant to be illustrative of China’s rising influence. It is doubtful that dedicated corporate EMD managers would benchmark themselves to this version of the CEMBI. The CEMBI Diversified, for example, shaves China’s weighting all the way to 8.7%, effectively distributing the balance across the other 41 countries represented in that index.
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