Understanding the Risks of Going Local

Foreign investors have increased their exposure to Chinese local government bonds over the past year. But recent cracks in China’s financial system and a shifting geopolitical environment have increased the financial and reputational risks for foreign investors holding these securities. This note analyzes these shifts and their implications. The findings are:

Foreign appetite for local government debt has soared: Global investors increased their holdings to over 11.5 billion yuan ($1.8 bn) by the end of 2021, from 2.5 billion yuan ($362.8 mn) at the end of 2018. Beijing’s liberalization steps have made these securities more accessible, and investors have been drawn by high yields and opportunities to diversify their fixed income portfolios. Yields and trends in foreign holdings of central government debt suggest further growth ahead.

COVID and property market turmoil have increased local financial risks: The property market slowdown and COVID-19 outbreaks are putting pressure on local government finances. The probability of local government bond defaults remains low, but valuation risk is prominent and could be amplified by possible local government financing vehicle (LGFV) bond defaults.

Reputational risks are growing and still underappreciated: Geopolitical tensions have led to a substantial increase in the reputational risks of owning Chinese securities, due to possible ties of companies to forced labor, military-civil fusion, audit non-compliance, and other problematic practices. Our proprietary dataset shows that local government issuers present similar risks, but foreign investors have been slow to recognize them. Links to forced labor and military modernization are the most salient risks for foreign investors.

Reputational risk is quantifiable and manageable: Reputational risk awareness is particularly important for global investors given the low liquidity in local government bond markets and thus limited options to close out problematic positions in the case of a crisis. The good news is that reputational risks remain heavily concentrated in a few areas. Active risk management can help weed out the bad apples, reducing the need for broad-based exclusion of local government bonds from portfolios.

Posted April 7, 2022
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Sidelined: US-China Investment in 1H 2019

US-China tensions further escalated in the first half of 2019, amplifying political risk for investors. Both sides ratcheted up bilateral tariffs following the breakdown of trade talks in May. The Trump administration then raised the stakes further by placing Huawei on the “Entity List”, restricting the ability of US suppliers to do business with the Chinese firm. China reciprocated, announcing to create an “Unreliable Entities” list of its own.

Posted August 1, 2019
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The Future is Now

China’s Q2 2018 Balance of Payments (BOP) figures show important deviations from past patterns, and point the way toward China’s BOP future. This note analyzes the most important data points and discusses the implications amidst US-China tensions and an otherwise deteriorating external environment for China. The key findings are:

A shrinking goods trade surplus is melting China’s current account surplus: Despite frontloading of exports in response to looming US tariffs, China’s goods trade surplus shrank 20% compared to last year to the lowest in five years for a second quarter. The deficit in services trade remains unchanged, driving down China’s quarterly current account surplus to just $5.3 billion. After a deficit of $34.1 billion in Q1 China is on track for the first annual current account deficit in a quarter century.

Strong bond and equity investment inflows sustained the financial account surplus: In Q2, China saw the largest portfolio securities surplus in history at $61 billion, primarily into the government bond market. That was sufficient to offset other outflows in the capital and financial account, as well as capital outflows that might be hidden within the services trade deficit. Last quarter was roughly in line with Beijing’s best-case scenario in the coming years, with stronger portfolio inflows offsetting the inevitable outflows from diversification by Chinese households and corporates.

US-China frictions could disrupt this new equilibrium, paving the way for further yuan depreciation: Despite the relatively healthy conditions in Q2, China’s currency still depreciated by 5.55% during the quarter. If the US-China dispute further erodes China’s current account balance and changes the psychology around further portfolio inflows, China may have to resort to further depreciation of the exchange rate to resolve BOP pressures and re-ignite investor appetite for Chinese securities.

Posted October 19, 2018
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