A FEW WEEKS ago I spoke to an economist at one of the world’s largest and most respected hedge funds – they invest central bank money amongst others – and in the process encountered one of the market’s biggest bulls on Chinese debt.
His evangelistic zeal on the topic blew me away and I left the call in less than two minds about whether to take a punt on a China bond ETF.
I didn’t, and the shocking devaluation of the renminbi last week would have left me immediately out of pocket if I had.
But his arguments for investing in Chinese domestic bonds resonated, not least because taking a bullish stance on China onshore debt struck me viscerally as being so contrarian that it is almost perverse.
My thinking, and that of many China watchers, is that surely China’s vast domestic debt pile will fall over a cliff as the economy enters its first significant slowdown in almost 30 years.
Local governments will struggle to service their debt mountain, having sold off most of the land they have used to pay coupons and redeem paper during the last few decades, during which time China has built the world’s third largest bond market from scratch. Default and debt restructuring seem such a huge risk that only the bravest would enter that arena.
The passionate spiel coming from the other end of the telephone line persuaded me otherwise. It’s not about credit, you see, it’s about rates. And even if it were to be about credit, the authorities won’t allow it all to collapse – at least not while they still have vast foreign exchange reserves and a huge asset pile in the form of SOEs and other tangible assets at home and abroad.
So add that element of this “Beijing put” together with what surely looks like the most obvious downward interest rate dynamic currently prevailing in the mainstream capital markets and you can see where the hedgie is coming from. And his company has put its money where his mouth is. They’re long Chinese domestic bonds, both at the national and local government level.
Hedge fund evangelical reckons there is sufficient government firepower to render credit risk a non-question
MAKING BETS BASED on a calculated assumption that a government will step in and support bond markets has often proved little more than pure gambling. Michael Hasenstab of fund manager Franklin Templeton hoovered up almost half of the Ukrainian bond market a few years ago, building up a stake of around US$8bn-equivalent.
The Russian annexation of Crimea, previously Ukrainian sovereign territory, prompted a collapse in the Ukrainian domestic bond market and Mr. Hasenstab’s stake is now worth roughly half of his initial investment. He and other holders of Ukrainian debt are now involved in a workout dialogue with the government. I guess there never was a viable “Kiev put” in a country that sits close to the failed state silo with such impoverished national coffers.
By contrast the Beijing put is made of rather more substantial stuff, and the hedge fund guru was wont to portray the Chinese domestic bond market in the context of the US or Japanese domestic bond markets. In fact according to IMF official data, China’s public debt to GDP sits at around 32%, while Japan’s is at 226%, the UK’s at 90% and the US’s at 73%. China’s national government debt numbers may look good, but debt at the household, corporate and municipal level has grown at a stratospheric rate since the financial crisis.
China bears put the country’s total debt to GDP at around 280%. But the hedge fund evangelical reckons there is sufficient government firepower to render the credit risk element of the China government bond equation a non-question. For now at least.
HIS HEDGE FUND has been long for a while – and it’s worked. Government bonds have rallied. The Chinese government bond yield curve has steepened over the past year and for taking minimal duration risk at the one-year point you’d have been rewarded handsomely, with yields having dropped from just under 4% a year ago to around 2.3% late last week for short tenor risk.
If China’s recent stock market collapse and various government interventions to prop up the market – which have been seen in some quarters as a novel form of quantitative easing – and last week’s renminbi devaluation are anything to go by, there are two conclusions to support the bond bull’s case.
The first is that the Chinese economy is slowing to an extent that is deeply worrying to the authorities and perhaps by more than the 7% GDP growth most recently stated in the national income accounts. The second is that the authorities are on top of it (to the extent that they can be) and are willing to intervene in markets to keep everything afloat.
Following the June cut, short-term Chinese interest rates are at 2.75%. There’s rather a lot of room to cut further from that level.
Assuming that China’s economy is slowing dramatically, that deflation waits in the wings, that the Beijing put is now at work and that China is not facing a financial market Armageddon where unprecedented destructive market forces are unleashed, then you would have to be a bull of Chinese domestic debt. Last week’s devaluation hasn’t changed that equation.
