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Appeal of safe-haven asset


Chinese government bonds will continue to attract foreign capital after the pandemic ends

Foreign holdings of Chinese government bonds (CGBs) have been surging since the sudden outbreak of the novel coronavirus, but can such strong demand continue into the post-pandemic era? Judging by the advantages of CGBs in terms of their attribute as a safe-haven asset, yield attractiveness and risk diversification, we think that increased holdings of CGBs will help enhance risk-adjusted returns of global investment portfolios. Therefore, the tendency will be for foreign investors to increase their holdings of CGBs in the future.

Since the global outbreak of the novel coronavirus, foreign capital inflows into the CGBs have totaled $116.1 billion. The strong momentum of inflows has continued in 2021. Since the start of this year, foreign capital of $37.7 billion has flowed into the CGBs. In response to the economic slowdowns because of the pandemic, developed countries, especially the United States and those in Europe, have launched unprecedented quantitative easing programs, resulting in abundant liquidity in the capital markets.

Previously, when the US and Europe rolled out massive stimulus packages, liquidity often flowed into emerging markets in pursuit of higher returns. However, things are different this time. According to data from Emerging Portfolio Fund Research, the cumulative capital inflowing into the stock markets of emerging countries, excluding China, has been only slightly higher than that before the pandemic. Local currency-denominated government bonds in emerging markets, excluding China, have witnessed net capital outflows since the pandemic broke out. In sharp contrast, renminbi-denominated assets have shown strong resilience and attractiveness during the same period.

That is to say, most of the liquidity created by economic stimulus policies of developed countries has either circulated within the developed markets or flowed into China. But the question is, can renminbi-denominated assets, especially the CGBs, continue to attract foreign capital inflows after the pandemic ends?

To start with, compared with sovereign bonds issued by other emerging markets, the CGBs have increasingly displayed the attributes of safe-haven assets. Observing the performance of sovereign bonds and the net foreign capital inflows during the three major shocks to emerging markets after the global financial crisis, the CGBs have demonstrated strong resilience. Amid market stress, the return on CGBs has been on a par with that of their counterparts issued by developed countries, and significantly higher than the return on their counterparts issued by other emerging markets.

When the COVID-19 pandemic broke out at the beginning of 2020, the government bond interest rates of emerging markets and even some developed countries rose sharply, driven by the term premium, whereas the interest rate of the CGBs experienced a continuous decline.

From the perspective of net capital inflows, local currency-denominated bonds issued by emerging markets experienced a massive foreign capital net outflow amid the stress, while there was limited capital outflow from the CGBs. In March and April of 2020, even though foreign investors turned net sellers of CGBs, the net outflow was not only subdued but also short-lived. At that time, amid the liquidity drain, all sovereign bonds, including the US Treasury bonds, experienced sell-offs to varying degrees. In a nutshell, considering the performance on the rate of returns and capital flows during the pandemic, the CGBs continued to show the attributes of a safe-haven asset.

Second, the CGBs deliver attractive returns. The yield spread of the CGBs over US Treasury bonds is likely to narrow in the second half of this year. However, even if the US 10-year Treasury yield increases to 2 percent (which is a high bar, judging by the current conditions) and 10-year CGBs yield hits 3 percent by end of the year, there will still be a 100-basis-point margin of safety, which is higher than the historical average. Furthermore, we expect the short-end and the belly of yield spread between the CGBs and the US Treasury bonds will stabilize within the range of 150 and 200 basis points, still an attractive yield pickup.

In terms of the developed markets, the yields on German and Japanese government bonds are around 0 percent and the US 10-year Treasury bond yield is expected to rise potentially by 100 basis points over the next year amid inflation pressure. In comparison, the yields on the CGBs, either from the dynamic or the static perspectives, will be more appealing to investors. On the other hand, compared with high-yielding government bonds issued by some emerging markets, the CGBs provide relatively higher risk-adjusted returns and involve subdued exchange rate risks.

Last but not least, the CGBs could help increase the risk-adjusted returns of global investment portfolios. Whether one type of asset could advance the efficient frontier of investment portfolios and improve the risk-reward performance of the portfolios depends on the asset's yield and its correlation with other assets within the portfolios.

Seemingly, at the interest rate level, the US Treasury bonds have displayed positive correlation with the CGBs. This, however, does not mean the interest rate of US Treasury bonds will have strong spillover effects on that of the CGBs, or changes in the former will directly cause changes in the latter, because both rates are driven by common fundamental factors. As a matter of fact, our empirical research shows that the CGB yields are relatively insensitive to US Treasury yields.

Looking ahead, we believe that foreign investors will continuously increase their holdings of CGBs overall. From the perspective of active investing, the higher yields on the CGBs and the lower sensitivity to US bonds could help enhance the risk-adjusted returns of global investment portfolios. From the perspective of passive investing, the inclusion of the CGBs into the FTSE World Government Bond Index this October means that about $110 billion of foreign capital is expected to flow into the CGBs over the next three years, about 8 percent of the net supply of the CGBs.

So far, foreign investors account for about 10 percent (around $0.34 trillion) of total CGB holdings, far below the average level of 20 percent in emerging markets. As the CGBs are included in global indexes, and as China deepens financial reforms, the Chinese bond market will be gradually integrated into the global markets, which, in our view, will in turn trigger both active and passive inflows of foreign capital into the CGBs. Therefore, we believe that the strong overseas demand for the CGBs is becoming a new normal.

Peng Wensheng is chief economist and head of Research Department at the China International Capital Corporation Limited. Zhang Jundong is an economist in the Research Department at the China International Capital Corporation Limited.

The authors contributed this article to China Watch, a think tank powered by China Daily.

The views do not necessarily reflect those of China Daily.

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