Yuan bonds remain alluring amid volatility as China looks inward

It is part of Chinese economic policy to allow the yuan to continue to appreciate, and the reason is that the Chinese government is converting its economy away from being investment- and export-driven to a model relying more on domestic demand. The only way to give domestic consumers purchasing power is to allow the yuan to strengthen, and there is absolutely nothing that the Chinese authorities have said that would suggest policies in this respect have changed.

However, there are two significant headwinds for the yuan. The first comes from the considerable weakening of the Japanese yen. Being an export competitor of China, the depreciation of the yen, all other things being equal, will inevitably weigh on the appreciation momentum of the yuan. 

The second issue is the strengthening of the US dollar. Many commentators anticipate the dollar becoming a lot stronger in five to 10 years, and this view will presumably impact the outlook for the yuan. However, if this really happens and the yuan retreats against the dollar, in the context of the resurgence of the US consumer, the outcome is that China’s exports will be supported, the trade balance and current-account surplus will swell, and foreign-exchange reserves will continue to increase from their current high level, resulting in even more favourable fundamentals for the yuan. 

This somehow suggests that there is actually a limit to how much the yuan can depreciate, and a medium-to-long-term appreciation of the currency seems extremely likely. 

With regard to China’s latest credit reform that has raised investors’ concern about the outlook of Chinese banks, first of all, and as we might recall, Chinese authorities did limit funding for one day in the money market, but they have subsequently been kinder to the banking industry and have injected more liquidity. This supports the view that the Chinese government has absolutely no interest in seeing any problems emerge within the banking system. 

Another point worth mentioning is that the Chinese banks that are allowed to issue in the offshore yuan bond market are only the very strongest ones, including the Bank of China, the Agricultural Bank of China and China Development Bank. Since these big names are so important to the Chinese economy, just as in any other country, they are being monitored closely by the government.

It is worthwhile to look at the creditworthiness of the sovereign entity itself when assessing the overall strength of the banking system. China, in terms of gross government debt to gross domestic product, has significantly lower debt than many other countries, especially the euro zone, at about 20 per cent. 

Even with the considerable local government debt and contingent debt, in terms of the special purpose vehicles that were created to provide fiscal stimulus to the economy in 2008 and 2009 included, the total gross debt-to-GDP ratio of China is only around 65 per cent, which would make many Western governments extremely envious.

On the other hand, China has huge cash reserves worth maybe 7 per cent of GDP, while its holdings in state-owned companies are probably worth 75-80 per cent of GDP. This indicates that China has a very healthy balance sheet, with assets at least equal to its liabilities. 

From this point of view, we believe that China has a very strong sovereign basis, which reassures the strong creditworthiness of these big Chinese banks. 

After the strong issuance in the primary offshore yuan bond market earlier this year, there has been virtually no issuance at all in Asia generally, including the US-dollar market, over the past couple of months. This is not an uncommon phenomenon in Asia, as investors took a breather amid recent volatility seen in emerging-market debt. 

On the other hand, as July and August are the holiday season, it helped explain the seasonal factor that contributed to the muted activity in the primary market. However, we can see that the pipeline is very strong and there will be companies that just have to come back to the credit market to roll over their funding.

One of the interesting traits of the offshore yuan bond market is that very few of the companies issuing in the market are actually required to do so. This is because they tend to be very large and liquid organisations with access to many sources of funding. This characteristic is undoubtedly a good thing for investors, as it means that the liquidity positions of these companies are very good. It also means that from time to time, there might be a pause in issuance, and we are currently in this stage. 

However, we have seen a strong recovery in the offshore yuan bond market, and we believe that issuance will pick up when the strong pipeline starts to open up again, probably next month. 

 

Geoffrey Lunt is director and senior product specialist for Asian fixed income at HSBC Global Asset Management