Gentlemen Prefer Bonds … Even in China

Chinese stocks finally made the grade!

Index provider MSCI announced recently that it would include China A-share stocks in its popular emerging-market index for the very first time!

The moment was widely heralded as a coming-of-age for China’s mainland stock markets … Chinese stocks listed in Shanghai and Shenzhen.

Financial pundits, including several newsletter gurus, layered on the hype. One claimed the MSCI deal marked “one of the most important days in the history of investing …”

Well … sort of …

In reality, the actual inclusion doesn’t even take effect until summer 2018.

And initially, less than three-quarters of one-percent of the MSCI Emerging Markets Index will be allocated toward China’s A-shares.

But it’s a start. And it’s an important step in the right direction so China can open its financial markets to the world.

Until now global investors only had access to about half of China’s $8 trillion stock market, mostly through Hong Kong-listed shares. As a result, China is woefully underweighted in global stock market indexes, considering the country’s size.

Soon it will be easier for people around the world to invest in Chinese stocks and bonds.

China represents just under 20% of global GDP and accounts for 11% of worldwide trade. Yet Chinese stocks make up only 3.5% of the MSCI All Country World stock market index.

Eventually, the opening of China’s A-share listed stock market will live up to the hype.

About $1.6 trillion in assets track the MSCI Emerging Markets Index. So, Goldman Sachs estimates China’s A-share stocks could attract as much as $210 billion in capital inflows … not all at once mind you … but over the next five years.

Still, there’s another event on the horizon that could prove to be an even bigger deal for China’s financial markets:

The new “Bond Connect” program promises to open China’s fixed-income markets to the world.

A similar Stock Connect program allowed global investors to buy Chinese mainland stocks through Hong Kong. Now, the Bond Connect concept aims to boost investment in the Red Dragon’s bond market.

This could be an even bigger deal for China. More than $1 trillion of global fixed-income capital could flow into China’s domestic bond market over the next decade, according to Goldman Sachs.

After all, China’s bond market is already the world’s third-largest at $9.4 trillion in outstanding debt. Yet, there are very few global investors who have access to it.

Foreign investors hold just over $100 billion of Chinese bonds held by foreign investors, or less than 2% of the market.

And China has at least two big incentives to open up its mainland bond market to new investors:

First, Beijing wants its currency, the yuan, to become more actively traded in foreign-exchange markets. So it’s a great way to open up its financial markets, including both stocks and bonds, to overseas investors.

Second, China’s growth in recent years has been fueled almost entirely by debt issued domestically. This debt has been issued by either government entities or state-owned enterprises, which are backstopped by Beijing. By opening its bond market, China can entice international investors to fund China’s future growth.

And higher yields should beckon global investors. China’s 10-year bonds yield 3.5%. That’s much higher than comparable U.S. Treasuries at just over 2%. And European and Japanese bonds that yield less than half-a-percent!

Good investing,

Mike Burnick

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