China’s easing dilemma

China’s policymakers signalled a bias towards targeted fiscal and monetary easing at this month’s National People’s Congress (NPC) meeting in Beijing. Officials said monetary policy would be “neither too tight nor too loose.” But in addition to this Goldilocks state of equilibrium, they added the focus would be on counter cyclical measures.

Still, as easing cycles go, we think this one is slightly more restrained and targeted than those we have witnessed previously - and it will be carried out against a backdrop of general financial deleveraging. For example, the first-time inclusion of unemployment as an official macro policy priority reinforced the importance of policies aimed at social stability and support for domestic consumption rather than the financial sector.

China is caught in a dilemma. It must reduce its overall debt burden but is loath to do so given the potential negative impact on growth. As such, the deleveraging campaign that has characterised the past two years started to take real effect this year. For example, sales of Wealth Management Products (WMPs) have stopped growing, and some companies have defaulted on their bonds due to a tightening of social credit conditions.

Source: PBOC, Fidelity International, March 2019. Note: Adjusted TSF (total social financing) is loans plus entrusted loans plus all local government bonds. The usual TSF measure only includes special government bonds.

The intensifying trade war with the US has provided an added complication, and against this backdrop we were not surprised to see China offer more support to the credit market, particularly for state-owned enterprises. The People’s Bank of China (PBOC) has said it will encourage lending to small and medium sized companies and private enterprises instead of injecting direct credit stimulus.

More measures are possible but there are challenges too. Taking history as a guide, rate cuts have usually happened during bouts of industrial deflation, especially when the producer price index (PPI) showed fast deterioration. As PPI is at zero now, a rate cut is possible if prices slide further. But this time around, China’s aggregate debt is much higher relative to its nominal GDP, so credit stimulus may not be as effective as it previously was.

Implications for investors

At the same time, Beijing is pushing for yuan-denominated bonds to be included in bond indexes compiled by Bloomberg and others. Such a move will channel global capital into China’s domestic market.

Bond index inclusion is forcing global investors to look more closely at the onshore Chinese bond markets and the broader monetary policy framework. Some will be on a steep learning curve, as this would be their first exposure to China’s onshore bond markets. While many global investors have been focused on China for many years, they have typically only viewed the financial picture through the lenses of equities, FX, and onshore property markets.

In the past, China’s onshore bond market was overlooked by global investors due to its relative lack of development. International access has only been made readily available in recent years, but benchmark 10-year government bonds are increasingly becoming known as a source of negatively correlated, risk-free exposure to China.

The asset class provides income seekers with a higher yield than US Treasuries, at around 3.3 per cent, and, over five years, higher risk-adjusted returns than European or US investment grade bonds. However, China’s onshore bond market does present some risks that are difficult to quantify for international investors. These include cultural and language differences, concerns over data integrity and risks related to environmental, social and governance factors.

So, for the moment, international investors have been waiting and watching. But once the impact of new monetary and fiscal policies targeting a healthier private sector become apparent, and the inclusion of yuan-denominated bonds in mainstream indexes takes hold, the China’s onshore debt market could see significant inflows.

As we see it, the recent recovery in risk sentiment has been driven by improving credit conditions, a dovish US Federal Reserve and an easing of trade war tensions. Despite the Goldilocks monetary policy, the reiteration of financial system support for privately-owned enterprises should relieve further refinancing pressure and support credit markets. In this environment, we remain overweight on Asian credit risk and are focussing on credit selection as spreads recover.