In the past year, the question of whether RMB assets are investible for global investors has come up frequently. We have never fully understood the basis for this question, especially when the same question has never been asked of the likes of Argentina, which has had repeated defaults over the years, or cryptocurrencies - many of whose longevity is suspect. Geopolitics matter of course. But it is, in our view, important for global investors, especially those not based in the US, to keep in mind some essential economic facts that should prove to be more important than geopolitics in assessing the investibility of RMB assets.
- China runs the largest absolute size current account surplus in the world and, in theory, does not need foreign financing. Financial fragmentation in the world should, in fact, hurt savings deficit countries like the US more than China.
- RMB bonds, in particular, have had the highest Sharpe ratios in recent years, compared to other major bond markets. This is true for both USD- and EUR-based investors. This fact matters for not only reserve managers but also pension funds and other institutions with global mandates.
- Further, their low correlations with the other bond markets make them a good ballast to help diversify the overall risk of a global bond portfolio. From the perspective of a EUR-based bond investor, the expected return and the associated Sharpe ratio rise with RMB bond holdings. For a EUR-based global mixed asset (i.e., having both equities and bonds in the portfolio) investor, the optimal exposure to RMB bonds could be between 40-50 percent, we calculate. While this theoretical optimal allocation is unrealistically large, conversely, not having any exposure to RMB bonds could be detrimental to risk-adjusted returns.
- The PBOC is the only major central bank in the world that has refrained from conducting QE. If we exclude foreign assets, its balance sheet is only 16 percent of GDP, compared to 58 percent for the ECB, 32 percent for the Fed, and 127 percent for the BOJ. The implications are clear for the volatility of future inflation, the volatility of the yield curve, and future trends in the currencies and competitiveness. All of the above are consequential for the investibility of certain bonds in question.
In this note, we focus on the RMB bonds. China is historically dominated by a ‘bond culture’ partly because of the immense property sector, which has made Chinese households quite comfortable and familiar with the concept of debt and partly because SOEs (state-owned enterprises) prefer to issue debt to issuing equity. Different EM economies have either a bond or an equity culture. China belongs to the former camp due to these 'DNA' reasons. The overall size of the Chinese bond market is around USD21 trillion – the second-largest in the world, more than double the combined market cap of the Emerging Market debt markets and slightly larger than the combined market cap of European bonds.
At the same time, the equities market in China is less well-developed and the flows are dominated by active retail investors/traders, who account for some 80 percent of the turnover in equities. The total market cap of the on-shore Chinese equities markets is around USD15 trillion1.
We also focus, in our calculations in this note, on EUR-based investors, simply because of the daunting geopolitical headwinds that USD-based investors face in investing in Chinese assets and RMB bonds, in particular: making the case for RMB assets in the current circumstances is probably a lost cause for US-based investors, in our view. We have long argued that Europe would, in the end, adopt a neutral posture in this US-China spat and would refrain from joining sanctions initiated by the US against China unless the latter crosses Europe’s red lines, whatever they may be. This scenario, in our view, would also mean that Europe-based investors would eventually resume investing in Chinese bonds because the economic arguments are so compelling.
China does not need foreign financing, though it wants it
China has the largest external surplus of any country in the world. Its annual current account (C/A) surplus has averaged some USD328 billion in recent years – equivalent to around 2.0 percent of China’s GDP. Thus, in theory, China does not need foreign financing.
However, foreign capital comes with superior technology, business know-how, and corporate governance, all of which China yearns to gain. This is especially true for FDI (foreign direct investment) and equity inflows. On the other hand, bond inflows could help China promote the international use of the RMB.
In sum, technically, China does not need foreign financing. But China would prefer to have foreign investments because they are ‘smart money’.
On the other hand, savings deficit countries like the US and the UK would not benefit from fragmentation in the global financial markets. Together, these two countries are currently running some USD1.1 trillion worth of C/A deficits each year – equivalent to 4-5 percent of their GDP.
In Chapter 3 of the IMF’s latest GFSR (Global Financial Stability Report), the economists at the IMF point out that one standard deviation deterioration in financial fragmentation could lead to a 15 percent decline in cross-border financing. It seems to us that the countries that have instigated such a fragmentation of the global financial markets are themselves also vulnerable to their own strategy. What if China and the rest of the Global South divest from USD assets, as they seem to have begun doing, based on our research (‘Rapid Erosion of Dollar Dominance as a Reserve Currency, April 17, 2023) ? What would happen to the cost of borrowing for the US Treasuries?
China may want ‘smart’ foreign money; the US needs foreign money, any money from anyone.
RMB bonds have the highest Sharpe ratios
2021-2022 may have been a sobering period for China, the Chinese economy, and Chinese assets. But the Developed West also has struggled, for different reasons.
The charts below show the diverse performances of the various bond markets in recent years and over a longer history. Both charts are in EURs, unhedged, i.e., they are a proxy for the Sharpe ratios seen from a EUR-based investor.
The chart on the left shows that, in the past 15 years, the RMB bonds have generated by far the best Sharpe ratio. The US came in second, but everyone else in our sample had extremely low Sharpe ratios. We also show in this chart the Sharpe ratios of the various bond markets in the past five years. Here, we can see the stark underperformance of the bond markets in Europe, Japan, the UK, and Australia, with outright negative returns. All the while, RMB bonds generated an even higher Sharpe ratio, from both the numerator and a very well-behaved denominator. The outperformance of China is even more significant if we consider how bond prices in DM were supported by huge purchases by central banks through QE during most of this period.
Past performance is not a reliable indicator of future returns.
Source: Bloomberg and Eurizon SLJ Capital. The total returns on various countries’ bond markets are calculated using JPM GBI indices from Bloomberg, in EUR unhedged terms. The measure shown in both charts is annualised returns in EUR, divided by volatility. As of 31st March 2023.
The chart on the right above is based on the same data, but shows the Sharpe ratios over different periods: 2011-14, 2015-18, 2019-21, and 2022, to describe the recent history with greater granularity better. Most importantly, for 2022, we see extremely poor Sharpe ratios of all the markets except for the RMB bonds.
In sum, not only have the returns on RMB bonds been superior in both local currency and EUR terms over this long period, but so have their volatility and drawdown.
We recently published a note on the USD’s status as a reserve currency (the same paper as reference above). One of the aspects of this discussion is how the reserve managers look at their often oversized foreign reserve portfolios. Most central banks have a liquidity tranche and an investment tranche in their reserves. For the latter, the investment return and general investment performances matter greatly, because, after all, this is a part of the national wealth. Sovereign wealth managers need to exercise stringent professional discretion as private wealth managers. Eye-balling the charts above, one might see how odd the argument is for managers of large global bond portfolios to avert having exposures to Chinese bonds, and for them to contemplate if China is still investible.
RMB bonds still an effective ballast for global investors
The two charts above show the stand-alone performance statistics of the selected bond markets. We make the additional point in this section that adding RMB bonds would yield significant performance benefits in a global bond portfolio due to the correlation characteristics and the concomitant risk-suppression benefits.
The chart below summarises our simulation results, based on data from the past 15 years of how the return and the Sharpe ratio could be affected as the exposure to RMB bonds is increased incrementally, from 0 to 100 percent.
Past performance is not a reliable indicator of future returns.
Source: Bloomberg and Eurizon SLJ Capital as of 31st March 2023
The chart above shows that the bond portfolio's return would rise linearly with the addition of exposures to the RMB bonds. The overall return on the bond portfolio could rise from 3.9 percent (with zero exposure to RMB bonds) to 6.8 percent or so (if the bond portfolio only held RMB bonds).
At the same time, the Sharpe ratio of the portfolio would rise along a concave trajectory as the exposure to RMB bonds is raised, i.e., the benefits would be disproportionately large between 0 and 50 percent before tapering off thereafter.
The above simulations are for a pure global bond portfolio. For illustrative purposes, we conducted a similar calculation for a global bonds-equities (50:50) portfolio, as RMB bond exposures are incrementally introduced into this portfolio.
The charts below show that, again, the portfolio return would rise with the exposures to the RMB bonds. The Sharpe ratio, however, peaks somewhere between 40-50 percent of the portfolio. The size of the improvement in the Sharpe ratio from adding RMB bond exposures is slightly more pronounced with a mixed asset portfolio, compared to a pure bond portfolio.
The optimal exposure of a EUR-based multi-asset portfolio should, thus, have 40-50 percent of the exposures to Chinese RMB bonds, according to the optimisation calculations. Obviously, there are many reasons why this would not be possible or reasonable in practice. But our point is that, from an objective optimisation perspective, EUR-based investors could benefit from a large exposure to RMB bonds, to capitalise on its superior stand-alone performance statistics as well as its risk-mitigating correlation contributions to a global portfolio. In addition, the positive performance of the RMB over the years has also contributed to this result.
In turn, our findings also underscore the fact that, not only would China suffer from financial fragmentation (i.e., lost opportunities to import technology and good corporate practices), the sanctions-imposing nations, most of which are savings deficit countries, would also suffer from lower external financing as well as lost investment efficiency.
Past performance is not a reliable indicator of future returns.
Source: Bloomberg and Eurizon SLJ Capital as of 31st March 2023
The long shadow of QE
We pointed out back in 2009 that the Fed made a mistake perpetuating the QE program even when the credit crunch had abated. By deploying an unconventional monetary tool (QE) to achieve a conventional objective (inflation), the Fed had opened a Pandora’s box of macroeconomic risks, including (i) weakening discipline for fiscal prudence, (ii) sowing latent inflation pressures that could be unleashed from time to time, (iii) encouraging general leverage in the economy, due to the artificially depressed cost of capital relative to the natural rate of interest, and (iv) tilting the policy focus away from structural reforms toward monetary policy. All of the above has indeed happened in much of the Developed West and Japan. None of the above has been introduced in China.
The FAIT (flexible average inflation targeting) framework introduced in August 2020 was ill-timed and a mistake, in our view. The subsequent inflation overshoot is sufficient to more than offset all of the ‘under-performance’ (actual inflation being below the inflation target) in the US since 2008. As we argued at the time, the problem with FAIT was that not ‘letting bygones be bygones’ raised the question of how the Fed could judge when to rein in inflation and how much excess inflation was ‘enough’. Will the Fed offset excessive inflation with a period of low inflation from now on?
The other problem with FAIT was that it legitimised the Fed intentionally staying behind the inflation curve: the FOMC declared repeatedly in 2021 that they would not start hiking rates until the unemployment rate had reached full employment. Never in the recent decades had the Fed waited until they had reached their estimate of full employment before starting to retract what was a massively stimulative stance.
Worse yet, back in 2021 several Fed policy makers actually argued that the Fed should keep up the stimulus until the disadvantaged sub-groups of the labour force achieved full employment – an even higher hurdle than full employment for the broad economy – before curtailing monetary stimulus.
All of the above seem quite unbelievable but there has been little curiosity in academia or policy circles for a retrospective or introspection on the Fed’s policies since 2008.
The spurt in inflation in the major economies will make the US and other developed economies less competitive vis-à-vis Asia, which has seen much lower general inflation and virtually no wage inflation, with implications for the exchange rates in the future.
Importantly, another distortion that QE has imparted is a positive correlation between bonds and equities. Because of QE, bonds in the US and Europe have been positively correlated with the corresponding equities. If bonds and equities go up and down together, there are no diversification benefits from a traditional 60:40 portfolio. A 60:40 portfolio or a ‘risk parity’ based approach would effectively increase the leverage of the bet in one direction, at the expense of the implicit risk to the portfolio. This positive correlation between bonds and equities is why portfolio managers in the Developed West suffered so severely in 2022.
Coming back to China and the RMB bonds, the PBOC is the only major central bank that has refrained from conducting QE. Excluding foreign assets, its balance sheet is 16 percent of GDP, compared to 32 percent, 58 percent, and 127 percent for the Fed, the ECB, and the BOJ, respectively. This conservative policy stance of what we call the ‘Bundesbank of Asia’ should lead to lower inflation and lower volatility in inflation and interest rates in the future. It should also lead to a structurally strong RMB, in our view. The correlation between Chinese bonds and equities remains negative, as we believe it should be.
Not only are the economies of China and the West out-of-sync at this point in their business cycles, their monetary policies have also had a stark structural divergence. These disparate trends underpin the RMB bonds as a precious source of portfolio diversification for global investors.
We believe there will be no winners from financial fragmentation. Heightened geopolitical tensions could lead to a fall in cross-border capital flows. But since China has the largest excess savings in the world, and the US is the largest deficit country in the world, it seems to us that the US could suffer from lower external financing just as China would be deprived of ‘smart’ capital. This Pareto sub-optimal scenario may be unavoidable, but it is in our view not correct to argue that only China will be harmed. The RMB bond market is not only massive in size, it has been the best performing large bond market in the world in the past decade, and could bring significant diversification benefits to any global portfolio. Foreign investors choosing to avoid holding RMB bonds may forego such benefits. We believe RMB bonds will continue to perform well and the bond market will continue to thrive, mainly because of China’s still robust economic fundamentals supported by prudent monetary policies. In our view, RMB bonds are not only investible, they are indispensable in global portfolios.
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