While all eyes have been on the drama of the Chinese stock market, more are starting to notice the returns available on investment-grade Chinese corporate debt. Last month, the Communist government in Beijing dramatically loosened rules for foreign investment in China’s $6 trillion bond market.
The Chinese government 10-year bond is yielding over 1% more than the U.S. 10-year Treasury note, and top-rated corporate Chinese debt is paying almost 2% more.
What’s the Attraction of Chinese Debt?
If the Chinese economy is in a slowdown, why are Chinese corporate and sovereign bonds in such demand?
China is the world’s second-largest economy, with a huge bond market. The Chinese government is embarking on another round of economic stimulus (though, one much more subtle than those conducted by the Fed and ECB). To keep the balance sheet of the Peoples Bank of China (their central bank) from ballooning, the government is directing that state-backed or state-run companies issue corporate bonds to finance development and expansion. Investors know that these bonds are ultimately back-stopped by the government, which greatly reduces any chance of default.
In fact, this is the reason that many of these bonds have investment-grade ratings, compared to similar companies in India, Brazil, and other emerging markets. The Wall St Journal quotes Hayden Briscoe, who runs a $630 million Chinese bond mutual fund, as saying that China is unique among EM economies, in that it has no sovereign debt downgrade risk, and is still one of the strongest economies in Asia. With more government stimulus aimed at stabilizing growth at 7%, the Chinese bond market is set to keep the supply of new bonds growing.
What About the Fed’s Interest Rate Hike?
Most other nations are experiencing pain of varying degrees from the Fed’s imminent interest rate hike in the U.S. China is well-situated to weather any blowback, as the PBoC still has plenty of room to lower interest rates, if needed. Even after recent rate cuts, the benchmark interest rate in China is 4.85%, and major banks are well-capitalized. The present yields on both Chinese corporate and sovereign debt are high enough to cushion the blow from a rate hike in the U.S.
The Chinese government’s massive, unprecedented intervention into the stock market has demonstrated that it will not allow any large portion of the economy to collapse, further reassuring foreign bond investors.
Having Your (Rice) Cake and Eating It, Too
This points towards something that the Chinese government continues to wrestle with: it wants the fruits of a free market, but does not want economic turmoil to endanger its grip on political power. Since few living Chinese can remember how a free market works, it has led to everyone chasing sequential bubbles that guarantees huge returns, with the expectation that the ruling party will have their back when it comes crashing down. Investment strategy among China’s relatively small investing class apparently is “get in, get rich, get out before it all implodes.”
This dichotomy in economic policy is also evident in the government’s recent opening of the domestic bond market to foreign investors. While Beijing has rolled out the red carpet to mutual funds, institutional investors and central banks, the big foreign investment banks like Goldman Sachs, JP Morgan, and Deutsche Bank have been prevented from taking a “market maker” position. Only HSBC has managed to gain permission to underwrite bonds from state-owned lenders, which happened in 2011. By shutting out the TBTF banks from underwriting in their bond market, the Chinese seek to maintain ultimate control in case of a panic.
As China seeks to move the financing of their economy from state-backed banks onto investors both foreign and domestic, there will be no shortage of corporate or government bond issues. Ultimately, what everyone is “banking” on, is that Beijing can successfully transition the economy from a reliance on exports to a consumer-driven economy like the West. And if things get bumpy, everyone expects the government to dip into its huge foreign surplus to keep things under control.