VanEck: Why is China excluded from global bond indices?

Jun 15th, 2017 | By | Category: Fixed Income

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By Fran Rodilosso, head of fixed income ETF portfolio management at VanEck. VanEck is the provider of the VanEck Vectors JP Morgan EM Local Currency Bond UCITS ETF (EMLC). The fund tracks the JP Morgan GBI-EMG Core Index, offering exposure to bonds issued in local currencies by emerging market governments. As of the time of writing, the index did not include exposure to bonds issued by the Chinese government.

VanEck: Why is China excluded from global bond indices?

Fran Rodilosso, head of fixed income ETF portfolio management at VanEck.

A somewhat incredible fact of global bond markets is that the third largest market in the universe is not included in any major index. The reason for this is that the onshore Chinese bond market was, until several years ago, closed to foreign investors. However, a very deliberate, and sustained liberalisation will lead to changes for onshore Chinese bonds.

According to the data of the Bank for International Settlements, the onshore Chinese bond market in total has a market value of approximately $9 trillion (as of 30 September 2016), placing it third behind the US ($37 trillion) and Japan ($14 trillion). The recent addition of Chinese Government Bonds and the bonds of three Chinese policy banks to the Bloomberg Global Aggregate + China Index included $2.5 trillion in bonds, accounting for more than 5% of the index. Chinese Government Bonds would hold a similar weight in the Citi World Government Bond Index upon inclusion.

What steps has China taken to liberalise its domestic bond market?

China has taken several incremental steps over the past years to open up its onshore bond markets to foreign investors. This began with the introduction of the Qualified Foreign Institutional Investors (QFII) scheme in 2002, followed by the RMB Qualified Foreign Institutional Investor (RQFII) scheme in 2011. Both allow institutional investors that meet certain qualifications to invest in onshore bonds. Since 2012, investors accessing markets through these programs could access both the exchange bond market as well as the much larger and more liquid interbank bond market, subject to additional approvals.

Significant progress was made to open up the interbank market in 2016 with the introduction of a registration process that allowed certain types of foreign institutional investors to access the market directly. In 2017, foreign investors were given the ability to hedge currency risks in onshore derivative markets, and officials recently approved the creation of a “Bond Connect” scheme that will allow foreign investors to purchase onshore bonds through a trading link with Hong Kong.

Opening up China’s bond market to foreign investors is a priority for policymakers, and supports ongoing efforts to internationalise the Chinese yuan (CNY) and provide a much-needed alternative to domestic financing. In addition, the expected inflows from long-term foreign investors could help to ease domestic outflow pressures currently experienced.

What is preventing China’s inclusion today?

Despite progress in opening up markets, certain issues have prevented China’s inclusion in global bond indexes as operational hurdles remain. Investors must have a local onshore custodian, and the registration process has proven to be somewhat lengthy and burdensome. There is still a need for greater access to onshore hedging tools and certain tax rules remain undefined for foreign investors.

Most importantly, investors and index providers want some assurance that there will not be any backtracking of the progress made over the past two years. In a stressed market environment, there is also a fear of capital controls.

China’s impact on emerging market bond indices

Issues aside, index inclusion appears inevitable. The expected inflows will be in the range of $150 to $300 billion from emerging markets and global bond funds. From an emerging markets index perspective, the higher allocations to China would come at the expense of relatively smaller issuers including Poland, Indonesia and South Africa.

(The views expressed here are those of the author and do not necessarily reflect those of ETF Strategy.)

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