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Despite China’s growing corporate debt burden, Chinese credits are trading at unattractive levels. The reason is that demand from local Asian investors remains strong. As we expect this technical factor to continue for some time, spreads on Chinese credits will remain relatively low. We are cautious in this market.
China’s growth is increasingly driven by the use of ever more credit. China’s debt burden, especially corporate debt, has become a key concern for international investors.
Bonds of Chinese corporates are trading at very low spreads. Asian high yield bonds even trade 30 basis points lower than their US peers. Also within Asian markets returns are converging. The difference between high quality A rated companies and BBB rated companies has compressed to historically low levels. Investors do not seem to get paid for taking the extra risk on lower quality companies. The question that obviously comes to mind is: Why is that? And who are buying at these tight levels?
There is very strong demand from Chinese investors for USD-denominated Chinese bonds. Seemingly endless buying of especially Chinese banks has provided strong support for Asian bond markets in general, and especially for Chinese corporates. Asian investors today account for 76% of all buyers of newly issued Asian bonds. Five years ago, Asian participation stood at only 60%. In China, this trend is even more pronounced with 91% of the issued bonds being bought by Asian investors.
One of the major sources of funding for the strong China bid is a continued rise of US dollar deposits at Chinese banks. These grew by 22% in 2016 alone, adding up to USD 595 billion of new deposit inflows. Historically, the Chinese have always had sizeable dollar deposits but this further increase seems to have been the result of the 7% depreciation of the Chinese renminbi in the summer of 2016. Chinese citizens seem worried the renminbi will depreciate further and prefer to hold more dollars.
Logically, this would result in people moving more money outside of China into foreign assets. However, in 2017 the government has implemented stricter policies to prevent capital outflow. It has become almost impossible for Chinese residents and corporates to transfer money outside of China. The only way for most Chinese residents to get dollar exposure is to convert their renminbis into dollars at the maximum allowed by the government (USD 50,000 a year) and put them in their onshore bank accounts. In the first five months of 2017 dollar deposits at Chinese banks increased by another USD 193 billion, reaching USD 788 billion.
To be able to pay dollar interest on deposits and avoid currency risk, Chinese banks need to either lend out in dollars or invest in dollar assets. Historically, Chinese banks’ dollar deposits were used to provide companies with dollar loans. With the fast increase in USD deposits, supply of dollars outpaces demand. As a result, Chinese banks need to invest more in the dollar bond market. Onshore deposits are moved to the offshore branches of the Chinese banks, which they then invest in the offshore USD market.
Chinese banks have been increasing their dollar investments by more than 50% in 2016 to USD 90 billion, or 13% of banks’ total assets.
Most of these Chinese banks are relatively inexperienced in the dollar bond market and have a strong home bias. Chinese banks feel much more comfortable investing in dollar bonds issued by Chinese companies. They generally have a banking relationship with those companies via their own branches in China. The high risk tolerance of Chinese banks has resulted in very low risk premiums on Chinese corporate bonds. As a result, demand for Chinese credits from international investors has been declining.
Other Asian markets have been dragged along in this technical as many Asian investors have a regional restriction. As spreads in China narrowed, other markets saw an increase in demand as well.
Despite our concerns on China’s high leverage, we do hold several positions in Chinese credits within our Emerging Credits strategy and, to a lesser extent, our Global Credits strategy. As we expect this technical factor to remain with us for some time, spreads on Chinese credits will remain relatively low.
We are very selective given the limited absolute compensation and also the differentiation between good and bad companies. Many Chinese state-owned enterprises carry the same credit rating and the same yield due to expected government support. However, the underlying fundamentals and financial quality differ significantly. Company A and B may be rated the same and offer the same yield despite one being 8x more leveraged and showing 70% lower margins.
We prefer to be invested in state-owned companies that have a clear strategic importance to China and solid balance sheets. There are also opportunities in private companies with leading global market positions.