UBS Says In Five Years, Japan’s Bond Market Would Be Surpassed By China’s To Become World’s Second Largest

UBS Asset Management said in a report that overtaking Japan’s to become the world’s second largest behind the United States’, China’s bond market will double in size from the current $9 trillion over the next five years.

Local provinces and cities were prohibited from borrowing from banks in a law passed in 2015 and that is the underpinning that growth. Instead, as Chinese authorities sought to transfer some risks away from banks, they were required to borrow in the public debt markets.

“We believe more and more Chinese entities will raise capital in the onshore bond market, given that the domestic market is already large and liquid enough to attract new investors,” the Swiss fund house wrote in its report.

Just about on par with U.S. municipal debt size of $3.8 trillion, from the current $1 trillion, China’s local government bond market will grow to more than $3 trillion in the next three years, it predicted.

UBS said that China’s debt market is made into an attractive investment due to such growth prospects, coupled with the country’s financial reforms. It added that state-owned enterprises, local government bonds or issuance by the five largest banks may be selected for those with higher credit risk.

“In the aftermath of the global financial crisis, unorthodox monetary policy led to asset price inflation in all traditional asset classes. This in turn has created yield compression, with the amount of negative-yielding sovereign debt globally estimated at $8.6 trillion, according to Fitch Ratings (March 2017),” according to the UBS report.

UBS said that “there remains the potential for capital gains should bond yields move lower from their current levels” and that Chinese bonds, on the other hand, offer “attractive yields” on both a nominal and real basis. Chinese bonds’ “defensive characteristics” (investment grade and a from net creditor country) make them “attractive in a portfolio context”, the fund house also noted.

As China’s economic influence widens, a key risk to global markets have often been identified as the c country’s rising debt and moderating growth. Last month Moody’s flagged that its economy-wide debt levels were expected to increase further in the years ahead and downgraded the country’s rating from A1 to Aa3. The agency said that reforms were only likely to slow China’s growth rate.

Yet, China’s own government bonds may be signalling problems with the wider economy even though UBS may see opportunity in the bond market.

The 10-year Chinese government bond yield sank below the one-year yield, noted PIMCO’s emerging markets portfolio manager Isaac Meng in a note this week. Amid “a severe liquidity crunch in the interbank market”, such a sink happened only once before, on June 2013.

“The People’s Bank of China has clearly tightened monetary conditions, pressuring banks to curb corporate and mortgage lending while passing through higher lending rates to borrowers… On the margin, China’s monetary tightening and financial deleveraging will be a headwind to a rebound in global manufacturing and reflation in commodities,” Meng wrote.

“A persistent wholesale funding squeeze and yield-curve inversion in a relatively opaque and interconnected financial system are signals of strain; they should be taken seriously by both policymakers and investors.”

(Adapted from CNBC)

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