China’s Rising Presence in Emerging Debt Markets

GMO White Paper: China’s Rising Presence in Emerging Debt Markets, September 2017

China’s Increasing Presence in the Asset Class

  • Since the GFC in 2008, China boosted growth through a debt-financed investment spending binge. Aggregate debt-to-GDP ratio has doubled and now stands at about 258% of GDP
    • During this period, China contributed 57% of the world’s nominal growth in GDP and in doing so, sucked in commodities from all corners of the earth
  • More than half of GDP in incremental debt has been incurred by the corporate and state-owned enterprise (SOE) sector and the rest was split between government and households to levels that are, by international standards, not very alarming
  • China’s weight in the EMBIG benchmark of dollar-denominated sovereign and quasi-sovereign debt has gone from relative insignificance just five years ago to more than 8% as of June 2017 (second only to Mexico)
  • In terms of local debt markets, China is currently unrepresented but this is likely to change in the next 12 to 18 months
    • Authorities are taking aggressive steps to open the onshore debt markets to foreign investors which is a necessary condition to meet liquidity and transparency requirements for inclusion in, for example, JP Morgan’s GBI-EMGD local debt benchmark
  • China’s domestic government bond market is the 3rd largest in the world at about $1.8 trillion
  • Chinese weighting in the CEMBI index of emerging corporate bonds has gone from relative obscurity in 2009 to more than 20% currently

Valuation Considerations – External Debt

  • Our sovereign credit risk assessment process scores countries on their relative strength across 3 risk vectors – economic structure, fiscal sustainability, and external liquidity
  • Our statistical estimation techniques applied to economic data that is as accurate as we can ascertain, scores China as the strongest sovereign credit among the roughly 80 of our investable emerging market countries
  • China’s score Economic Structure is strong, owing to its track record of high and stable GDP growth, rising GDP per capita, and strong competitiveness, among other attributes
    • One of the few countries that has a reasonable chance of moving from middle income to high income in the next 20 years, following the footsteps of other regional economies like South Korea, Taiwan, and Singapore
  • External Liquidity is also very strong due to consistent surpluses in the current account of the balance of payments, massive foreign exchange reserves, and relatively low external indebtedness at both the sovereign and overall country level
  • Fiscal Sustainability: outsized state role in the economy makes it difficult to assess China’s fiscal policy. Fiscal deficits have been running in the 2-3% of GDP range for several years and government debt-to-GDP ratio is around 40%. These numbers place China squarely in investment-grade territory
    • But more conservative approaches to China’s public finance analysis quantify the fiscal impulse coming from debt-financed local government spending, state policy banks, and SOEs. On this basis, fiscal deficit could be as high as 10% of GDP and the debt-to-GDP could be double the 40% figure
    • Were this to be true, it would look more like a speculative-grade country
  • The fact that EMBIG currently trades at a spread of around 300 bps to Treasuries, there is little compelling reason to own China from a top-down perspective
  • Given that currently the benchmark is comprised entirely of quasi-sovereign names, might there be opportunities in this space for security selection?
    • Some of the quasi-sovereigns trade at spreads very close to or lower than the China sovereign credit default swap (CDS) spread. We do not think this makes sense as we believe that companies should offer higher spreads than their respective sovereigns
    • Of the SOEs that offer a spread higher than that of China sovereign CDS, relatively few meet our model’s valuation hurdle
  • We are also mindful of our indirect exposure to China – China’s impact on emerging countries mostly flows through the trade channel
    • Recently, China overtook the US in terms of the value of trade with the EMBIG subset of 65 emerging countries
    • We can imagine this continuing in light of the tilt toward nationalism in the US, countered with Xi Jinping’s unwavering commitment to globalization
    • Also underscores the negative impact that a hard landing scenario in China could have on the global market
  • Pattern to the types of countries that display a higher correlation to China’s PMI:
    • There is a significant relationship between correlation to China’s PMI and a country’s commodity dependence, measured by the ratio of commodity exports to total exports
    • Tend to have higher-yielding bonds
    • Conclusion is that there may be numerous ways to get indirect China exposure with a much higher yield than direct Chinese sovereign and quasi-sovereign obligations

Valuation Considerations – Local Currency Debt

  • Our local interest rate relative value model considers measures of term structure, rewarding countries with relatively steep yield curves, as well as real yield differentials relative to other countries and relative to the country’s own history
  • China scores poorly on 5-year and 10-year breakeven rates, indicative of a flat yield curve and market expectations of persistent low rates. China scores better on the level of real yields currently and relative to its history
  • We view CNY as a heavily managed currency and therefore does not fit into our standard relative value model which considers measures of momentum and economic cycle across countries
  • Future path of CNY will depend on some combination of economic fundamentals and “other considerations” which include Communist Party priorities for economic stability and growth, Trump administration trade policies, and policy desires to gain more global financial influence
  • Emerging local rates markets are more likely to be influenced by domestic macro policy factors, and G-3 monetary policy, than China’s domestic policy factors
    • Chinese rates have low correlation with other global rate markets but the rates markets with higher correlation with China tend to be low volatility, such as Thailand, US, Israel, and Singapore
  • Currencies that are most highly correlated with the CNY have some combination of the following characteristics: 1) high yield; 2) a high volatility; and 3) highly liquid and therefore convenient for risk hedging
  • When China enters the GBI-EMGD, its relevance will only increase. This should present us with choices for security selection alpha via direct exposure to China’s debt markets or via more attractively priced securities elsewhere in the opportunity set

Image Source: JP Morgan, Bloomberg, GMO