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Marcuard's Market update by GaveKal Research
The three-year-old Chinese offshore renminbi bond market set a new milestone last Friday: the first AAA issue by a foreign government. The Canadian province of British Columbia issued a one-year, RMB2.5 bln (a little over US$400 mln) bond yielding 2.25%. This is big news, for many different reasons.
The first is that this BC bond issue illustrates the growing ties between China and Canada. For two decades now, Canada has been selling Chinese people what they need (fertilizer, wood, oil, quality education, real estate in non-polluted cities, passports, etc.). As such, a tight relationship has emerged between the Hong Kong stock market and that of the Canadian dollar. Basically, when Chinese investors make money on Hong Kong equities they tend to recycle their profits into Canadian hard assets. With this bond issue, British Columbia is going straight to the source of Chinese capital and cutting out the middle-men.
The BC bond issue is also big news because it shows that opportunities still abound in the “dim sum” bond market. What makes more sense: owning 12-month paper backed by the British Columbia government yielding 2.25% in renminbi, or US dollar paper of the same duration issued by a somewhat dysfunctional US government, yielding 0.12%? The only way the latter option makes sense is if one assumes that the renminbi will fall by 2.15% or more in US dollar terms over the coming year. Of course, that may well happen… but with US economic data mostly on the softer side of expectations, and Chinese data on the marginally better side of expectations, it is not obvious that the multi-year appreciation of renminbi is set to reverse.
Which brings us to the more interesting question, namely why would British Columbia issue debt at a higher price than could be achieved in US dollars? One answer is that the resource-rich province is diversifying its investor pool so that, should there ever be another freeze in the US dollar bond markets (as there was after the Lehman bankruptcy, and as was threatened just a few weeks ago), BC will have another pool of investors to call upon. Which brings us to the most notable feature of the renminbi bond market: its complete lack of volatility. Indeed, over the past 18 months, Chinese offshore bonds (as measured by the HSBC index) have delivered total returns of some 6%, with a volatility of around 2%. That is much better, and much less volatile than what long-dated US treasuries have delivered.
Now anyone looking at the almost Madoff-like returns of renminbi bonds might be tempted to conclude that something fishy is going on. However, the truth is more mundane. China's policymakers know that they need to internationalise their currency for two reasons:
1) Remaining dependent on the US dollar to finance trade settlement, capital spending and other daily expenditures when the US financial system has been badly managed and badly regulated, simply adds unnecessary volatility to the economic cycle.
2) If China is to move its exports up the value chain, from cotton under-wear to earth-moving equipment and telecom switches, then it will increasingly have to provide its customers with financing options. And financing in your own currency is a lot less risky than becoming beholden to somebody else's. In that regard, China's main comparative advantage next to other emerging markets is that it has a deep, liquid and credible financial centre in Hong Kong. In the world of yesterday, Caterpillar would sell machines to an Indonesian mine, while Citibank provided the financing and Asian savings poured into US treasuries. In the world of tomorrow, Indonesian mines will buy machinery from Liugong Machinery, with loans provided by an Indonesian bank, which will have issued a dim-sum bond in Hong Kong, bought by savers in Japan, Korea, Taiwan, Hong Kong and elsewhere. Needless to say, a model of Asian savings financing Asian growth makes for a more stable cycle and renders Asian assets all the more attractive.
Of course, to make this dream possible, the renminbi and the dim-sum bond market need to be credible in their own right; they need to deliver steady and stable returns to investors. And lo and behold, this is precisely what is happening. Last week’s bond issue by the province of British Columbia comforts us in our belief that the internationalisation of the renminbi, and its consequences, will remain one of the key themes of the coming year. It also re-affirms our view that Chinese offshore bonds are the new German bunds; i.e., an anchor for any genuinely diversified portfolio.
