At the same time, there have been some vocal defenders of Chinese government bonds, most notably Bridgewater Associates, as part of reshaping the “risk parity” strategy for which they are best known.
Importantly, Exante Data’s weekly tracking of foreign-domiciled investors suggests the outflow continued through March 25. If anything, the output was sped up, and noticeably so.
There are competing theories about what is going on here that range from benign to pernicious.
For starters, we know that European fixed income managers have been steadily repatriating capital over the last three months. This trend reflects higher European yields, along with the impact imposed by Russia’s invasion of Ukraine. To date, we measure this repatriation flow at $43 billion in global bond markets, including China.
An alternative benign explanation is that the nominal yield advantage offered by Chinese government bonds has been eroded by the rapid appreciation of G10 markets, which encourages disinvestment.
For context, the five-year US Treasury yield rose a full percentage point in March, closing Friday at 2.55 percent. Comparable movements have been witnessed elsewhere, including here in Australia.
The only outlier is China, where yields have moved sideways through March. The performance increase is no longer there. In the space of five years, US Treasuries and Chinese government bonds are now on par.
While this perspective is intuitive, it does not align well with the nature of the shock, nor with the flows of funds that we can see within the G10 jurisdictions. The most basic problem facing global bond markets is duration absorption, where a combination of sustained primary fiscal deficits and active quantitative tightening (where bonds are sold by a central bank) must be financed by the private sector.
The figures involved are unprecedented and staggering, in the range of $1.5 trillion per year between 2022 and 2024, for the US, the eurozone and the UK. This is more than double the run rate prior to the pandemic, between 2017 and 2019. There are simply more bond sellers than buyers, and no one can be sure where the price will settle.
In this context, and especially given the aggressive stance from the Federal Reserve and the dovish stance from the People’s Bank of China (PBOC), the optimal place for global fixed income managers to seek refuge in March was Chinese government bonds. The long-touted diversification proposition stood and advocated inflows rather than outflows from China.
On the other hand, the most trafficked rumor in the last month was that Russia was liquidating its holding of Chinese government bonds, under the pressure imposed by financial sanctions and the selective quarantine of the Russian financial system by the cooperative society SWIFT.
The inclusion of the Central Bank of Russia (CBR) in the Western response added weight to this perspective. For reference, CBR has been aggressively diversifying away from US dollar exposure in recent years, such that about 21 percent of its $630 billion “war chest” is held in gold, and 13 percent is denominated in yuan (RMB). ; (This does not include assets in China held by Russia’s sovereign wealth fund.)
This hot take has not been confirmed by high-frequency capital flow data, including the PBOC’s foreign exchange intervention statistics. Furthermore, financial sanctions and SWIFT’s response have been routinely misunderstood in terms of their breadth.
The measures were consciously designed so that financial flows could still take place, including payments for Russian commodity exports to Europeand coupon payments on bond maturities.
The prospect of a Russian default, whether on sovereign or corporate bonds, is still very much up for grabs. But debt service is currently feasible and has been happening in recent weeks.
The best explanation for the sharp recovery in the ruble exchange rate is not that the CBR sold its RMB assets, nor gold either.
It reflects a combination of mandatory business receipts, coupled with tightening of capital controls, both for domestic residents and holders of Russian assets abroad.
sovereign risk premium
Through this process of elimination, we arrive at the most logical and pernicious explanation for Chinese government bond outflows.
Western investors are rethinking their involvement given the precedent that has been set with Russia and, in particular, given the context of passive inflows in recent years and significant risk exposure now.
The short-term concern is that China will provide demonstrable military assistance to Russia with respect to Ukraine, raising the possibility of secondary sanctions. The most realistic and longer-term scenario involves conflict in the South China Sea and, critically, Taiwan.
To be sure, the draft security agreement between China and the Solomon Islandswhile it fundamentally upsets the strategic balance in the Indo-Pacific if carried out, it is not considered a predicate for this form of escalation.
However, Western holders of Chinese government bonds are being forced to contemplate, not a new scenario, but a new playbook for a familiar scenario.
This implies that China inexorably exerts more geopolitical influence until a crisis is reached. The West then responds first with far-reaching financial sanctions, including liquidations of PBOC, SWIFT, and US dollars in general.
Although China would resist imposing capital controls in the context of its long-term ambitions to establish the RMB as a reserve currency, the possibility can no longer be ruled out in extremis..
This leaves Western holders of Chinese government bonds, supposedly a risk-free asset, facing not insignificant but catastrophic risk. Therefore, the recent departures, we believe.
Australia and Japan
To conclude, there have been two major countries that have consciously avoided investing in Chinese government bonds in the last two years.
We reported in this newspaper in May of last year that Australia’s retirement sector was divesting from China, even from a low base. We hope that trend has continued, including the Future Fund.
We also note that the world’s largest pension fund, the Government Pension Investment Fund (GPIF) in Japan, would determine in October, in terms of continuing to follow the FTSE Russell benchmark. GPIF duly opted out, and that will certainly influence the massive savings sector there, including pension funds, banks and life insurers.
The open question is whether US and European wealth managers, along with the index providers themselves, reconsider their structural engagement with China in these historic times.