How market reforms will boost appeal of Chinese stocks and bonds for foreign investors

• The next decade should see continuing reforms and significant structural changes in the Chinese economy, with profound implications for Chinese assets
• Despite the short-term volatility in Chinese markets, the strategic investment case for Chinese assets over the longer term remains strong

While regulatory tightening this year has raised questions among investors about Chinese policymakers’ strategic priorities, policy actions over the past few months remind us that Beijing remains committed to liberalising and reforming domestic capital markets.

China has taken several steps to promote cross-border capital flows, including the launch of the Cross-boundary Wealth Management Connect scheme in the Greater Bay Area and the southbound leg of the Bond Connect programme in September.

Offshore hedging tools for A-shares improved with the launch of the MSCI China A50 Connect Index Futures on October 18. It is endorsed by the China Securities Regulatory Commission, and it is likely to support further cross-border equity flows.

In addition, the establishment of a new Beijing Stock Exchange will help create a more diversified capital market structure and support the financing needs for early-stage small and medium-sized enterprises.
Looking further ahead, the next decade should see continuing capital market reforms and significant structural changes in the Chinese economy, with profound implications for Chinese assets and their role in global portfolios.

China’s asset markets have expanded rapidly over the past decade, and one could argue that they are now too big to ignore. Between 2010 and 2020, the size of China’s onshore equity and bond markets have increased more than three- and six-fold respectively, to become the second-largest in the world.

Yet, China’s onshore assets are often overlooked by foreign investors. Expect this to change. Further capital market opening and the chance for attractive returns will lead to a bigger portion of Chinese assets in global portfolios.

Foreign investors’ access to China’s onshore asset markets is set to continue to improve. The further opening up of China’s domestic capital markets is a key focus in the government’s 14th five-year plan.

While China accounted for more than 17 per cent of the global economy in 2020, its onshore assets remain under-represented in global indices. Chinese stocks make up about 4 per cent of global equity indices, while Chinese bonds make up around 7 per cent of global bond indices.

However, their weight is expected to expand as China continues broadening foreign investors’ access to domestic markets. Chinese government bonds’ phased inclusion in the FTSE World Government Bond Index, which began last month, is the latest example.

Also, the returns we project for China A-shares and government bonds sit comfortably above that for developed markets in the next 10 to 15 years.

A key factor is stronger demand from domestic investors as China’s expanding middle class put more savings into financial products. At present, more than 60 per cent of China’s urban household wealth is concentrated in real estate.

Most of the remaining 40 per cent is in cash and bank deposits. Over time, more people are expected to invest in stocks and bonds. Property market speculation faces more stringent regulation, and improvements in the social welfare system under the “common prosperity” initiative will reduce demand for precautionary savings in cash.

At the same time, Chinese government bonds are expected to continue to offer attractive yields compared to major developed market government bonds in the next 10 to 15 years.

While slower economic growth in China should put pressure on yields, policymakers’ efforts to deleverage the economy and promote further interest rate liberalisation should support yields.

Despite slowing growth over the past decade, average yields on China’s 10-year government bonds have held up relatively well, at 3.3 per cent in the past five years compared to 3.5 per cent in the previous 20 years.

On the equity side, the higher expected returns for China A-shares will come with higher volatility, which means a wider range of outcomes compared to developed market equities. This will improve over time, though, given that A-share volatility should decline as the market’s dominant participants shift from retail to institutional investors.

Chinese assets also provide global investors with opportunities for diversification, which some see as the only free lunch in investing. China A-shares and government bonds have historically shown low correlations with global assets.

That correlation is likely to rise as foreign investors’ participation increases. However, it will probably remain relatively low, given China’s distinct economic and policy cycles.

Despite the short-term volatility in Chinese markets, the strategic investment case for Chinese assets over the longer term remains strong. Expect China’s onshore equities and bonds to become more mainstream in global portfolios in the next decade, helped by further capital market reforms and attractive opportunities for returns.

Author: Sylvia Sheng, SCMP