Countless articles have been written in the past 10 years predicting (or warning) of China’s imminent financial demise, with the number of articles accelerating in recent years amid China’s debt build-up in the post Global Financial Crisis period. Investing on the basis of a “China collapse” view of the world would likely have resulted in more risk-averse portfolios in the emerging debt space and, hence, lower returns in recent years. Our investment process, which is heavily skewed toward finding underpriced securities (bottom-up) rather than making global macro calls, or even country calls, for the most part exempts us from having to take a view on topics such as if and when China is going to collapse. That being said, China’s presence in our asset class is increasing and, as alpha-focused investors, we are aware of our direct and indirect China exposures and the relative value of China exposures. This paper provides our readers with a glimpse into how we view China’s sovereign, quasi-sovereign, rates, and FX exposures.
China’s Increasing Presence in the Asset Class
China’s well-documented debt build-up has had a significant impact on the emerging debt asset class. Since the Global Financial Crisis in 2008, China has done the world a big favor by boosting growth through a debt-financed investment spending binge. The aggregate debt-to-GDP ratio of “China Inc.” (corporates, households, governments, and banks) has doubled and now stands at about 258% of GDP.2 During this period, China contributed over half (57%) of the world’s nominal growth in GDP, measured in US dollars.3 In doing so, it sucked in commodities from all corners of the earth.
As seen in Exhibit 1, more than half of the 100% of GDP in incremental debt has been incurred by the corporate and state-owned enterprise (SOE) sector. The rest was split between government and households to levels that are, by international standards, not very alarming. The increase in SOE and corporate debt has had a dramatic impact on certain emerging debt benchmarks. Exhibit 2 shows China’s weight in the EMBIG benchmark of dollar-denominated sovereign and quasi-sovereign debt. Two things are notable. First, in the past five years China has gone from relative insignificance in this benchmark (with a weighting akin to countries like Lebanon, Kazakhstan, Panama, and Lithuania) to a weighting of more than 8% as of June 2017, second only to Mexico. Second, the entire China component of the benchmark is comprised of quasi-sovereign issuers that are, by the criteria of index inclusion, 100% owned by the Chinese government (more on this later).
In terms of local debt markets, China is currently unrepresented (please see “The What-Why-WhenHow Guide to Emerging Country Debt: 2017 Edition” for more detailed discussion), but this is likely to change in the next 12 to 18 months. The authorities are taking aggressive steps to open the onshore debt markets to foreign investors, which is a necessary condition to meet liquidity and transparency requirements for inclusion in, for example, J.P. Morgan’s GBI-EMGD local debt benchmark.4 China’s domestic government bond market is the third largest in the world, at about $1.8 trillion, which dwarfs the entire market capitalization of the GBI-EMGD, at $1.2 trillion. It follows, then, that China’s weighting will eventually be at the 10% cap. Exhibit 3 shows the current weightings of the benchmark and our estimate of the pro-forma weightings after China is fully incorporated into the index.5 Weightings of Brazil and Mexico, which are also at the cap, are unlikely to change, but several countries could see their weights drop by a percentage point or more.