Article / 04 October 2017 at 10:30 GMT

Weekly Bond Update: Setbacks ahead but the dragon will bounce back

Fixed income Specialist / Saxo Bank
Denmark
  • China is going through a difficult shift to domestic consumption-driven growth
  • Inefficient, failing enterprises need to be consolidated into stronger companies
  • Beijing is  interested in semiconductors as part of shift to high-tech industries
  • US dollar notes issued by policy banks may appeal to investors

By Althea Spinozzi


Following its upgrade for Portugal, the rating agency Standard & Poor's didn’t lose any time in revising its rating for one of the world’s most watched economies: China. The agency downgraded China to A+ from AA-, marking its first sovereign rating cut since 1999.

The rationale behind the downgrade lies in the fact that in order to support its high GDP growth, the east Asian nation has had to take on massive leveraging; and if Beijing wants to achieve its 2020 GDP target, China's total debt ratio could rise to 77% in just four years.

State-owned enterprises are among the biggest borrowers in China, as the government identifies priority industries and deploys money and policies in order to support them. For a number of years, China has stepped up efforts to accelerate the development of its industrial cluster in metallurgy, machinery manufacting, biopharmaceuticals, new building materials and furniture manufacturing industries. 


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The Wuhan to Guangzhou express ... China's extensive high-speed rail network demonstrates its growing importance in the world economy. Photo: Shutterstock


High-speed rail (HSR) is the perfect example of what the Chinese government has been able to achieve over the years through patience and perseverance. China's HSR is the fastest long distance train in the world. Not only does China have the fastest trains; it also has about two-thirds of the world’s high-speed rail tracks in commercial service today, exceeding 22,000 km in total length.


This train is the perfect demonstration of China’s growing importance in today’s world and economy. It is also evidence of the country’s capabilities to achieve outstanding results through methodical investment.


In this environment, investors have looked at China with interest and have been selectively investing in the country. However as leading economic indicators are declining, many wonder whether it is about time to pull the plug and look away from the nation.


Challenging transition

China’s biggest challenge at the moment is to transition from a growth model to a consumption-led model. As a matter of fact, the country in the past few years has primarily been a manufacturer of Western-style goods. So the majority of investments have been made to satisfy international demand, without considering whether said investments may be viable for the future. 


Domestic wages have now increased, eroding the cost advantage of producing in China. On the top of that, Western firms get a large share of profits for every Chinese item sold, as they hold intellectual property rights for the biggest part of high-technology goods.


This is why it is important for China to reassess investment, and consolidate the manufacturing sector, so that inefficient and failing enterprises can be consolidated into stronger companies that can drive productivity. This will free up cash to allow new and better companies to enter the market and give technology innovation the funding needed to serve domestic Chinese demand where firms will be able to secure larger share of profits.


This may partly explain what is happening within the Chinese real estate sector. A couple of weeks ago, Chinese real estate stocks fell, as the government imposed stricter lending rules in order to avoid an overheated real estate market. This made many Chinese investors realise that actually the stocks that they are holding could be riskier than what they had believed.


The two biggest developers’ stocks, China Evergrande Group and Sunac, fell sharply but rebounded by the end of last week as the market calmed down and investors realised that there is enough data to support a strong real estate market in underurbanised China.


The government intervention in the real estate space was a smart move in order to move China closer to a consumer-led economy. Only half of the population lives in urbanized areas and lower house prices will enable the growing Chinese middle class to move to cities where they will have easier access to services and education. This implies that even though the housing market at the moment is cooling off, this sector will be still supported by steady flows of Chinese moving from the countryside to the cities, pointing out to the fact that weakness in this sector is just temporary and that as the middle class grows, opportunities in this sector will arise.


High tech focus

This is the first step towards a new China and its goals are made clear with the “Made in China 2025” plan announced in 2015 where high tech development is a focus. The Chinese government seems to be particularly interested in the semiconductor sector. As a matter of fact, China has long been the largest market for semiconductors and the Chinese government has made several attempts to build a local industry but without luck.


Semiconductors are used in nearly every electronic device yet China still imports approximately 90% of the semiconductors it uses, from automotive to industrial controls. Various investment firms have tried in the past few years to purchase several semiconductor companies with Lattice being the last one. 


Unfortunately for China none of these bids have been successful; the Lattice deal was not approved by US president Donald Trump last week. But this will not discourage China from trying to pursue new partnerships in the near future.


China's bond market

China government bonds














Source: Bloomberg

If we look at the Chinese bond market, we can see that China’s yield curve is very flat and inverted in the medium term. As a matter of fact, the spread between China 10-year and 5-year yields is very tight (just 3 basis points; compare this with the US Treasury spread between 5-year and 10-year yields is 42 basis points), while the 7-year yield is 10bps higher than the 10-year. 

Chinese bond yields have been rising over the past couple of months, while global yields have been declining because economic data has been weaker and the Chinese government has been buying longer dated maturities. This could be good news, as the higher cost of funding will force corporates to deleverage, but at the same time it will push weaker companies out of the market.

Investors interested in playing the Chinese story may want to look at US dollar notes issued by policy banks such as China Development Bank, Agricultural Development or top commercial banks such as Bank of China and China Construction Bank.

A name that has drawn our attention from both an equity and a bond point of view is China Construction Bank, the world’s second-largest bank by market capitalisation. If you look at its US dollar subordinated 3.875% 2025, it offers a yield of approximately 3% to 2020 call, a nice pickup of +150bps from the US Treasuries for a solid BBB+ issue.

You can also decide to buy straight government Chinese bonds; however there are only two USD issues and both of them are quite illiquid. At the moment there are talks regarding rising up to $2billion in a new 10 year china government bond. However we will need to wait until the 19th National Congress of the Communist Party of China taking place on October 18 in order to better understand what will be the Chinese government plans for the next few years.


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The National Congress later this month will give a preview of the direction
 China is likely to take in the next few years. Photo: Shutterstock


In conclusion, we remain positive on China even though there are signs of weakness. As a matter of fact, it is true that the country is changing, but only for better as it has identified its weaknesses and is eager to capitalise on its strengths. 

We believe that shifting the focus from exports in an effort to stimulate internal economic growth through consumer expenditure will prove vital and supportive for the Chinese market. In the mid-term, certain industries such as real estate will suffer. However increasing domestic urbanisation will be supportive in the long run.

– Edited by Robert Ryan

Althea Spinozzi is a sales trader at Saxo Bank

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