Tapping China, the World’s Third Largest Bond Market By Goldman Sachs

Earlier this month, Chinese bonds debuted in the benchmark Bloomberg Barclays Global Aggregate Index, marking another step toward greater globalization of China’s capital markets. We sat down with Goldman Sachs Research’s Kenneth Ho and Danny Suwanapruti, who shared their thoughts on the inclusion and what it means for investors.

Can you set the stage for us? How big is China’s bond market and what are the investor implications of this index inclusion?

Kenneth Ho: The move is significant. Adding China to a benchmark global bond index — with two more global indexes likely to follow suit — will attract many investors to China’s domestic bond market, some for the first time. The market has grown rapidly over the past decade, reaching $11 trillion at the end of 2018 from $1.6 trillion at the end of 2008. Yet foreign investors own just 2% of the debt. Global investors in the past were held back by capital restrictions, hedging difficulties and insufficient market liquidity, among other factors. We estimate that more than $1 trillion of foreign investment will flow into China’s bond market over the next decade, and index inclusion will be a meaningful driver of such flows.

Danny Suwanapruti: It’s important to keep in mind that the majority of our estimated $1 trillion inflow will likely come from central banks and sovereign wealth funds, and they are less affected by the impact of index inclusion. Nonetheless, the index inclusion reflects significant progress in the development of the domestic bond market. Even as China grew to become the world’s third largest bond market, market access limitations and other operational issues kept it from being added to global benchmarks until now. In recent years, authorities have made significant efforts to address these issues, including providing overseas financial institutions direct access to the interbank bond market in 2016 and introducing the Bond Connect program in 2017, which allows global investors to make onshore bond purchases via accounts in Hong Kong.

We’ve seen similar moves to open up China’s local stock market to foreign investors, such as adding China A-shares to the MSCI Emerging Markets Index and launching a Stock Connect programWhat are some of the drivers behind China’s moves to open its bond market, specifically?

KH: We see a number of benefits to China having a more sophisticated bond market. Historically, China’s economy has been over-dependent on bank lending. Having access to the bond markets gives borrowers a more diversified source of funding, reduces the burden on domestic financial institutions and provides savers more instruments in which to put their money. Attracting foreign flows provides additional benefits. On a macro level, they help offset capital outflows and increase the usage of the RMB in international markets. On a micro level, the presence of foreign investors can improve credit analysis and spur the development of the corporate bond market. A case in point is the decision by policymakers to allow foreign rating agencies to start providing credit rating services in China.

You’ve both been on the road talking to investors. What is top of mind for them?

DS: I’m frequently asked by investors how the index change will affect other holdings in their portfolios. We expect China’s weighting in the Global Aggregate Index to increase to a final weight of around 6% over the 20-month implementation period, which means that the weights for other markets will be revised lower as they effectively make space for China. In the Global Aggregate, the weights will come down the most for USD, EUR and JPY markets. However, if China is included in the emerging market bond indices, such as GBI-EM Global Diversified, the weightings of other EM markets will be revised lower. In addition, some investors have expressed concerns that China may not be ready for index inclusion, as there may be insufficient liquidity in Chinese government bonds for index-tracking investors to replicate the inclusion portfolio. As such, we estimate that about 10% to 20% of investors may opt out of the index.


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