Chinese cuckoo in EM bond nest

by , 13th April 2018

The 28 March 2018 was an important day for the index world. Not because it was Lady Gaga’s birthday, but because that was the day that Bloomberg Barclays indexes announced that Chinese RMB government bonds were going into the Bloomberg Barclays Global Aggregate Index. The incorporation of China into all the main benchmarks is perhaps one of the most important operations that that the index providers have had to navigate.

It is important because China is the world’s second-largest economy, second-largest equity market and second-largest bond market, but it has been under-represented in the global indexes and consequently, in our investment portfolios. It is also important symbolically as it illustrates China gradually moving to take on a role as a leading nation globally, a role it lost in the 19th and 20th Centuries. Something that President Xi has emphasised several times.

Strictly speaking only Chinese government and policy banks’ bonds are going into the index, representing about 55% of the Chinese bond markets, but not for the moment Chinese corporate bonds. That is a step too far for now, but in time Chinese corporate bonds will be coming into the benchmarks.

Foreigners’ access to the Chinese equity and bond markets has been highly regulated. The sheer size of the Chinese markets makes it difficult for them to suddenly internationalise. As a trading nation, the Chinese have a strong interest in not dislocating the global financial system and they do not want to be exploited by it. Therefore, China is entering the global financial system in a series of small steps, gradually deregulating over time. This is sensible; the alternative would be like a python trying to swallow a fridge-freezer.

The slow and gradual entry into the some of the equity and bond indexes reflects the success of their approach. The entry into the Bloomberg Barclays Global Aggregate Index is another small step along the way. In order to be eligible for the index a bond must be investment grade (China is rated A1 or A+) and must be sufficiently tradable and free from capital controls for international investors.

The addition of China to the Barclays Bloomberg indexes will be phased in over 20 months starting April 2019. China will then be about 5% of the index, about the size of the UK. The index will still be dominated by the US dollar (43%), the Euro (22%) and Japanese Yen (17%), reflecting their large government deficits. For investors in the Global Aggregate ETFs, this will not be huge change, although most will welcome the added diversification.

In ETF-land there are only two physical ETFs from iShares and SPDR. These are relatively new ETFs, both less than six months old, but they have already collectively gathered over $1Bn. Their relative newness reflects the difficulty the issuers had getting enough funding to start these ETFs. The index has 24,000 bonds, so to take a representative sample of the index requires a new ETF to be exceptionally well funded; something that even some of the biggest players struggled to do for a long while.

China has not gone into the alternative Citibank or JPM global bond Indexes yet, but it cannot be far away. The introduction of China to the emerging market bond indexes will be much more significant given the popularity of the ETFs in this area. Some of these indexes have a 10% country cap which will limit the potential dislocation, but even so there is the potential for some countries to suffer some selling as the Chinese cuckoo squeezes into the emerging market bond nest. Let’s hope the index providers again take a pragmatic approach.

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