The growing role of China and India in emerging market bonds

August 17, 2018 09:30
The Reserve Bank of India has been prudent with respect to monetary policy, despite a drop in inflation. Photo: Reuters

Diversification across asset classes has become an essential part of investing for the long term. Investors are increasingly looking further afield to deepen their portfolio diversification and lower total risk as they seek attractive returns.

Emerging markets debt (EMD) is becoming increasing well established as a source of diversification in investor portfolios, reflecting in particular its historically low correlation to developed market debt. The EMD asset class will continue to see strong growth and we believe that China and India will become increasingly important drivers of this. Here we take a look at opportunities and scope for growth afforded by these two markets in particular.

China, China and China

China’s US$11.4 trillion bond market has become too important to ignore. Amid the beating drums of a trade war with the US and the falling value of the renminbi (RMB), bond yields in China are bucking the trend. As of end-July 2018, the yield for the World Government Bond Index is at 1.57 percent and the Global Aggregate Index was 2.05 percent.

While China’s bond yield is no longer as attractive as the start of the year, we are still optimistic that the easing cycle has further to run. As we have seen in the equities space, structurally, the Chinese bond market should be a major beneficiary of wider index inclusion expected in the years ahead.

Another thing worth noting is that the trade weighted renminbi currency index is now trading below 93 against the China Foreign Exchange Trade System (CEFTS) basket currency, which appears cheap compared to past levels. At these levels, we believe a large part of trade war risk has been priced in. The People’s Bank of China (PBOC) has little incentive to allow long-term RMB weakness against the US dollar largely due to the risk of encouraging domestic capital outflows.

China is a good risk diversifier in a rising interest rates environment. The Chinese bond market is primarily domestically-driven and has historically been less correlated to other emerging and developed market bond markets, providing potentially good diversification benefits for international investors, particularly amidst global shocks. Both China’s Ministry of Finance and the PBOC revealed easing policies in July to support growth with more active fiscal policy plans and more lenient lending rules. On balance, we think there is scope for yields to head lower from here, combined with a more attractively valued currency.

Diversifying into India

Like China, Indian bonds are a good diversifier owing to their relatively low correlation with other global fixed income markets, and domestically oriented nature of the Indian economy and bond market. Indeed, capital controls on foreign ownership have kept India from being included in most global benchmarks. Thus, some international investors may be unaware that India is Asia’s second-largest bond market, with assets near US$1.5 trillion, where bonds trade with relatively high liquidity and with a yield of around 8 percent.

Meanwhile, the Indian economy is developing rapidly with real GDP growth forecast at 7.3 percent this year and 7.5 percent over the next two years. A wide range of reforms are in the process of being implemented including the Goods and Services Tax bill, insolvency and bankruptcy code and improvement in the country’s ease of doing business, which should enhance India’s economic standing.

Having institutionalized the formation of the monetary policy committee and implemented the inflation targeting framework, the Reserve Bank of India (RBI) has been prudent with respect to monetary policy, despite inflation falling to 1.5 percent in June 2017. While there were cyclical and temporary pricing pressures, inflation has structurally declined.

Responding proactively to increasing oil prices and other inflationary pressures, the central bank raised the benchmark rate to 6.25 percent in June and further to 6.5 percent in August despite still soft industrial credit growth. Meanwhile, the market has been very quick to price in policy rate and inflation risks, resulting in a fairly valued yield curve.

The RBI also continues to pursue wide ranging financial market reforms, including: efforts to clean up balance sheets; reducing the incidence of fraud; reducing financial assets distortions; broadening and deepening markets by allowing state government securities to be correctly valued; and increasing the collateral cost of non-rated state securities, as well as granting more entities the right to short-sell securities.

The full effects of such reforms are probably still two to three years down the line. However in time the combination of such actions should help to support investor confidence and bring down India’s country and inflation risk premiums. In turn, this will likely drive sovereign ratings upgrades and reduce the cost of capital, making India a more attractive place to invest.

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Head of Asian Fixed Income, Aberdeen Standard Investments