China is set to attract more foreign capital, which could have big implications for investors in EM debt.
4 minute read
China’s economy dwarfs most of its emerging market peers, but it has not traditionally attracted foreign capital flows commensurate with its vast size. That may be about to change.
Two key drivers are leading China to hoover up more overseas capital. The first is its declining current account surplus. Morgan Stanley analysts forecast China will run a deficit this year, for the first time since 1993.1 The government is loosening rules over foreign investment as it seeks to plug the gap.
The second driver is China’s inclusion in several global market indices. The weighting of Chinese A-shares in the MSCI EM equities index is rising and China is also on the brink of joining major fixed income benchmarks, potentially sparking outflows from other index constituents. The combined effect of these developments is likely to be increased competition for capital among smaller emerging economies dependent on foreign financing.
There are legitimate worries about the shifting tide of global capital towards China and whether this will mean a falling supply of capital for other emerging markets, exposing them to tighter financial conditions and lower growth rates over time.
In 2007, China’s current account surplus stood at about ten per cent of GDP, but this had declined to 0.4 per cent as of the end of 2018, according to official figures. Short-term headwinds have contributed: the US-China tariff dispute has hit exports and a rise in commodity imports has made China’s current account balance more sensitive to global oil prices.
Over the longer term, China will probably manage to avoid persistent deficits. Despite the government’s attempts to rebalance the economy towards consumption-led growth, China’s domestic savings rate remains high, at around 45 per cent of GDP. A large proportion of these savings has been sucked in by large-scale fiscal stimulus packages, but as China moderates its growth targets and unwinds stimulus the current account balance is likely to stabilise in positive territory, argues Saroliya.
Nevertheless, the recent decline in China’s surplus has provided the government with an incentive to liberalise its financial system and bring in more foreign capital. Beijing initially restricted access to onshore markets, allowing a select group of foreign investors to participate via the Qualified Foreign Institutional Investor (QFII) programme, which issued quotas to pension funds and other large institutions. Now new channels are opening to offer a wider range of investors access to onshore RMB-denominated assets.
The China Interbank Bond Market and the Bond Connect – which uses the same exchange infrastructure as the Shanghai-Hong Kong Stock Connect – have allowed foreign bond investors much greater access to the onshore Chinese market.
“One significant consequence of these moves towards market liberalisation is that they have cleared the way for China to be added to global indices, whose inclusion portfolios need to be replicable for international investors,” Ritson adds.
The process started with equities. Chinese large-cap A-shares have featured in the MSCI Emerging Markets Index since mid-2018 and their weighting is being ramped up to over three per cent of the index in a two-stage rebalancing process in 2019. As the MSCI index is tracked by more than US$2 trillion of active and passive funds, the rebalancing could lead to outflows of US$40-55 billion from other emerging markets over the next six months, according to estimates from UBS.2
A similar reallocation of fixed income capital is likely after China joins major bond indices. The Bloomberg Barclays Global Aggregate Index was the first of its kind to add China, launching a 20-month phasing-in period on April 1, 2019. On the roster for inclusion are Chinese government bonds and those issued by policy banks to fund state projects.
This is already influencing capital flows. A Reuters analysis of official data shows that, as of the end of April, offshore holdings of Chinese government bonds were at the highest level ever recorded, at RMB 1.1 trillion (US$163.7 billion), an increase of RMB 19 billion over the previous month.3 Overall, the Global Aggregate Index inclusion could prompt US$100 billion of inflows into Chinese bonds, according to our estimates.
The Chinese local-currency bond market could swell by a further US$120 billion if China is added to the FTSE World Broad Investment Grade Bond Index, which is due to announce a decision on China’s inclusion in September. China is also on the JPMorgan Chase & Co watchlist for inclusion in two more indices – the JPM GBI-EM Diversified and EMBI Global Diversified – potentially adding another US$20-30 billion to the inwards rush of capital.
The overall scale of the projected inflows is relatively modest in the context of China’s US$13 trillion bond market, nevertheless the net result will be positive for Chinese government bond prices. The trend may also have a wider macroeconomic impact by expediting the yuan’s ascent to international reserve currency status, potentially sparking more foreign investment in China’s corporate bond market over the longer term.
“The capital gravitating towards China will come from both managers that passively follow the benchmarks as well as active investors eager to take advantage of attractive inflation-adjusted yields on Chinese bonds. Correlations between Chinese fixed income and developed markets have traditionally been low, offering active managers additional diversification benefits,” says Ritson.
The impact elsewhere could be negative, however, as much of the capital flowing into Chinese bonds is likely to be reallocated from other emerging markets. The risk is most pressing for the smaller economies present in the JPMorgan local-currency indices, which tend to be reliant on foreign capital.
If China is added to the GBI-EM index, as expected, its weighting is likely to reach the upper limit of ten per cent after the implementation period of at least ten months, which would reduce the weighting available for other index constituents. Morgan Stanley estimates Colombia’s share of the index could drop by 1.5 per cent, for example, potentially resulting in US$2 billion of outflows from Colombian bonds.
The low yields offered by Chinese bonds could mitigate some of the knock-on effects on China’s inclusion, however. “Given that Chinese bonds yield less than many smaller markets in the index, some investors are likely to underweight China to maintain a higher allocation to the other markets. And the phased implementation should limit distortions. But bond markets such as Malaysia and Russia could see relatively significant outflows, introducing a negative technical factor that investors should consider alongside other macro risks,” Ritson says.
Push and pull
As China exerts an ever-greater gravitational pull, competition for foreign capital is likely to heat up across emerging markets. But there are steps policymakers can take to ensure they continue to attract their fair share of investment.
A wealth of academic research shows that while capital flows are influenced by global macroeconomic conditions such as monetary policy in advanced economies, country-specific ‘pull’ factors play a big role in determining success. Studies of global capital flows found that the quality of domestic institutions, idiosyncratic country risks and the strength of fundamentals were major drivers of capital in the post-crisis period, along with ‘push’ factors such as overall risk appetite and US interest rates.4
“These findings suggest policymakers can attract foreign investment by making domestic institutions more resilient and improving macroeconomic policies. In an ever-more competitive EM universe, these factors could be important in separating the winners from the losers,” Ritson adds.
- ‘The transformation of China's capital flows,’ Morgan Stanley research note, February 2019
- ‘EM FX: Implications of the $140bn MSCI EM shift,’ UBS, March 2019
- ‘Foreign investors raise China holdings as index inclusion begins,’ Reuters, May 2019
- Marcel Fratzscher, ‘Push factors versus pull factors as drivers of global capital flows,’ Vox CEPR Policy Portal, August 2011