China Update

New China

China’s Ministry of Finance made two important announcements today.  For the first time, China indicated its intentions to reduce the amount of yuan-denominated bonds it offers in Hong Kong.   It will issue CNY14 bln of bonds in H2 17.  This is the smallest since 2010.  It will complement the yuan issue by issuing $2 bln of USD-denominated bonds.  

The changing fortunes of the yuan have seen its deposits in Hong Kong have been nearly halved from the CNH 1 trillion reached at the end of 2014.  Chinese officials have tried to curb outflows and arrest the slide in the yuan, which has fallen for three years.  In addition to capital controls, the PBOC is thought to have helped engineer a liquidity squeeze in Hong Kong that makes it expense to be short.  According to Bloomberg, the overnight rate in Hong Kong is averaging the highest in at least three years here in 2017.

The US-dollar issue will be the first in over a decade.  Scarcity will likely translate into tight pricing.  The five-year dollar note sold in 2004 yielded about 60 bp more than the comparable US issue at the time, according to Bloomberg data.   The supply may be calibrated to facilitate the expansion of Chinese banks’ offshore expansion.

After finishing 206 near 3.05%, the 10-year (generic) yield rose to 3.70% by early May.  It has subsequently pulled back.  Today at 3.585%, it is the lowest May 5.  It is the fifth consecutive decline and eight of the past 11 sessions.  After a firm Q1, the Chinese economy appears to have lost some momentum, and the official deleveraging push appears to moderate.  That said, the one-year yield is at 3.63%, keeping the curve inverted.

The Federal Reserve is widely expected to hike the Fed funds target range tomorrow.  The last two times the Fed hiked, the PBOC quickly followed with a 10 bp increase in the reverse repo rate. While investors will scrutinize the PBOC’s actions tomorrow and a move is possible,  it seems unlikely that they repeat the snugging.

Capital outflows have slackened (with the help of controls), and the quarter/half end could be disruptive.  President Xi speech in April emphasized a higher priority will be given to financial stability, which also jives with ideas that ahead of the key meeting in early Q4, officials want to avoid market unrest.

A week from now, June 20, MSCI will announce whether China’s A-shares (trade in the mainland markets)  will be included in its emerging market indices.  A few months ago, MSCI modified its original proposal to include 169 issues rather than 448.  All of the companies in the revised proposal are accessible via the HK-connect program.  By doing so,  MSCI addresses several objections from foreign fund managers, including access and repatriation.

Although some global asset managers have become more sympathetic to including China’s A-shares, there are plenty of reservations.  Trading halts in the mainland and suspensions in HK frustrate international investors.  In Shanghai, some 77 stocks were suspended or 5.8% of the total as of June 1, according to a Reuters report.  MSCI’s stock selection sought to avoid shares that were suspended for more than a month.

When MSCI declined to include the A-shares last year (for the third time), it cited three main reasons, having to do with access, suspension of trading, and local regulators insisting on pre-approval for financial products that are linked to A-shares.   Limited the inclusion of A-shares to those accessible on the connect program addresses the access issue.  Suspension and market data issues appear to remain open.

It seems like a close call.  Chinese officials want it, and related capital inflows could help blunt the outflows.  MSCI officials seem to want to push ahead if possible to begin what appears to be a multi-year process.   Chinese shares (that trade in HK, and in ADRs) account for about 25% of the MSCI emerging market equity index.  The proposed A-share inclusion would account for about 0.5% in the index; a modest step.  Over time, the China’s shares may eventually account for 40% of the MSCI emerging market equity index.

The squeeze, at least partly engineered by China officials, sent the yuan sharply higher in late May.    After making its point, officials seem to have pulled back, and the yuan has returned to narrow range trading since early this month.   The  IMF’s authoritative report on the currency allocation of reserves.  In terms of reserve allocation, central banks appear to move at glacial speeds.  We do not expect a significant shift into yuan, which the IMF now breaks out, alongside the other reserve currencies.