Conclusion: China’s decision to open up its bond market to foreign investors is likely a major catalyst for widespread internationalization of the yuan. Furthermore, we believe this decision has major implications across asset classes globally over the next 10-20 years.
Yesterday, we published a note on the intermediate-to-long term outlook for the Chinese consumer, and within that note, we briefly touched on China’s policy announcement to open up its interbank bond market to qualified foreign institutional investors. The key takeaways were: a) to accelerate capital flows from abroad by opening up its domestic securities market and b) to make its currency more attractive to foreign central banks by broadening its use globally. Traditionally, trade has been the main way for foreign holders of yuan to return money to China. By opening up its $2.1 trillion interbank bond market, China is now creating new avenues for foreign investors to invest in China.
We believe this decision has major implications across asset classes globally, particularly as it relates to the dollar, commodities, and U.S. corporate and government debt over the next 10-20 years. But before we get into key takeaways at it relates to investment opportunities, allow me to briefly summarize the reforms China is putting in place:
- China will let foreign financial institutions invest yuan holdings in China’s interbank bond market. As of the end of July, 97 foreign financial institutions including Goldman Sachs and JP Morgan Chase have received approvals from the securities regulator for investment in local currency bonds and equities.
- Expanding upon a program started with Hong Kong in June ’09, China will open up cross-border yuan settlement to foreign central banks and clearing banks.
- Further proposals are out to allow foreign investors to win quotas to invest in China’s yuan-denominated A-shares.
- Shanghai is reported to be considering foreign investment in yuan-denominated private equity and venture capital funds.
Combined, these reforms are significant, as it expands yuan transactions beyond just trade settlements. By granting foreign institutional investors greater access to investment opportunities, China is likely to spur global demand for yuan-denominated assets, ranging from securities to savings deposits. Furthermore, we believe that with this increased demand outlook, the yuan will receive incremental upward pressure over time, as popularity and investor comfort grows.
From an international FX reserves perspective, we believe this news is also bullish for the yuan from both an appreciation standpoint and from a diversification standpoint. As investor confidence grows, so should the confidence of foreign central bankers as it relates to holding yuan-denominated assets. In July, China agreed to a three-year currency swap with Singapore worth 150 billion yuan in addition to the 650 billion yuan of outstanding swap agreements with Indonesia, Malaysia, South Korea, Hong Kong, Argentina, and Belarus.
So what does this all mean as it relates to investing? First, we believe this is likely to be a catalyst that accelerates a likely secular up-trend in the yuan’s FX rate. We believe in the yuan as a percentage of international FX reserves will grow substantially over the next decade or two as foreign central banks diversify their FX exposure away from U.S. dollars. The latest data from the IMF supports our view that the U.S. dollar as a percentage of international FX reserves is mired in a secular down-trend that is not likely to end anytime soon. After falling from 71.5% in 1999 to 62.2% in 2009, the dollar continued its decline in 1Q10, dropping to 61.5% of global FX reserves. China has been leading the charge away from the U.S. dollar: in June it reduced its holdings of U.S. Treasuries by the most ever on a monthly basis, favoring Japanese government and Korean treasury bonds of late (+$20.1 billion and +$2.45 billion, respectively Jan-June). China’s KTB holdings grew 111% Y/Y in Jan-June period and the country is on pace to buy roughly 4 trillion won of KTB’s by year-end.
We are at the start of what looks to be a secular shift among global investors away from a low-growth, low-interest rate environment in the U.S. and towards high growth, high(er) interest rate environments in parts of Asia – particularly in the Indonesia, Singapore, Thailand, Malaysia and, of course, China. Malaysia today posted a +8.9% 2Q10 Y/Y GDP growth figure and raised guidance for the full year – citing a pickup in domestic growth in spite of slowing growth in advanced economies. Contrast that with TGT’s top line miss and soft guidance from this morning, and you can see clear as day that the world is changing and that capital will continue to chase yield either through growth or high interest rates.
Lastly, we feel that the Chinese economy will benefit from increased access to foreign capital. As growth slows in the Western economies, any investment within China catered towards producing goods for a Western consumer will slow. The broadening of China’s capital markets may ultimately serve to direct investment towards China’s domestic industries where development is needed in order to accommodate its growing consumer base. On the margin, this is a bullish catalyst for the Chinese consumer and, as a side-effect, bullish for the goods they will need (agricultural commodities, automobiles, electronics, etc.). Obviously, these structural changes won’t be fully developed in the near term, so we’ll continue to manage risk throughout the lengthy, long term ascent of the Chinese consumer.