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Investment flows to mainland China rose as more index providers, such as MSCI, FTSE Russell and Bloomberg, announced to include China stocks and bonds in their indices. Foreign investments in China's domestic bond market recorded 404.1 billion yuan in 1H18.
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Foreign investors tend to increase investments when RMB is strengthening. We expect the impact of exchange rate on foreign portfolio investments to weaken, as foreign investors are able to better hedge against CNY risks going forward.
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Capital inflows through the portfolio investment account will likely increase RMB exchange rate volatility.
MSCI, the largest global index provider, announced on September 26 that it would consider a further weight increase of Chinese A-shares. At the same time, FTSE Russell, the second largest global index provider, announced to include Chinese A-shares in its FTSE Global Equity Index Series. A shares will be categorized as secondary emerging market, effective June 2019.
China's market liberalization, combined with the inclusion of China stocks and bonds into global indices, stimulated an increasing amount of cross-border financial inflows, which in turn underpinned RMB exchange rates and offset the impact from narrower current account surplus to some extent. The pace of market opening continued to accelerate in 2018 (Table 1). Firstly, the trading quota for Shanghai-HK and Shenzhen-HK Stock Connect on a single day was quadrupled. Secondly, the currency authority made it more convenient for foreign investors to hedge against CNY risks when investing in RMB-denominated assets. Thirdly, the government further liberalized capital flows, which eased foreign investors' concerns regarding repatriation of their investments.
Financial market opening not only relieves some of the external pressures on China, since the U.S. has been appealing for greater openness from China, but also helps to attract investment inflows to mitigate the impact from the narrowing current account surplus (Figure 2).
According to the People's Bank of China, foreign investors bought 525.5 billion yuan and 346.2 billion yuan in China's domestic stock market and bond market respectively in 2017. In 1H18, foreign investments in the domestic bond market amounted to 404.1 billion yuan, larger than that in 2017.
MSCI initiated the partial inclusion of China A-shares in its indices, with a 2.5% inclusion factor, in May 2018, and then increased the weights from 2.5% to 5% in the August 2018 Quarterly Index Review for the MSCI Equity indices. In September 2018, MSCI launched a new round of consultation on further weight increase of China A shares in the MSCI indices. Specifically, MSCI considers to increase the inclusion factor of China A Large Cap securities from 5% to 20% in two phases, 7.5 percentage points in each phase in May 2019 and August 2019 respectively. Secondly, MSCI proposes to add ChiNext to the list of eligible stock exchange segments from May 2019, Thirdly, MSCI may add China A Mid Cap securities with a 20% inclusion factor in one phase from May 2020. In addition, as it is mentioned above, China A Shares will be included in the FTSE Global Equity Index Series as a Secondary Emerging Market on June 2019, and the size tranche will be 20% in June 2019, 40% in September 2019, and 40% in March 2020.
In our previous report, we estimated that with approximately USD1.9 trillion (active and passive) AUM tracking the MSCI Emerging Markets index (A shares weighted at 0.39% of the index), there will be about RMB47 billion of inflows into A shares induced by the initial inclusion of China A shares in May, and additional RMB47 billion inflows into A shares after the Foreign Inclusion Factor (FIF) was raised to 5% in August. As Figure 5 shows, the aggregate cross-border capital inflows via the Shanghai-HK and Shenzhen- HK Stock Connect stood at 224.1 billion yuan in the first eight months of 2018. Moreover, the QFII investment quota was increased by USD3.3 billion or RMB21.4 billion and the RQFII quota by RMB22.4 billion during Jan.-Aug. 2018, some of which also flowed to China A share market.
Furthermore, Bloomberg announced to include Chinese central government bonds and policy bank bonds in the Barclays Global Aggregate Index from April 2019. Considering active and passive funds tracking the index, we estimate additional 470.1 billion yuan and 574.8 billion yuan will be allocated to China's bond market in 2019 and 2020 respectively. FTSE Russell also said to review whether to include Chinese central government bonds in its indices in March 2019.
The news alone has made Chinese central government bonds more attractive to foreign investors. Data shows Chinese central government bonds held by foreign investors as a percentage of its outstanding volume increased from 5.0% to 8.0% in the first eight months of 2018. And Chinese bonds held by foreign investors accounted for 3.3% of the outstanding volume at end-August 2018, up from 2.4% early 2018. Moreover, 59% of newly issued Chinese central government bonds in Jan.-Aug. 2018 were bought by foreign investors (Figure 6).
We observed that foreign investors steadily increased their investments in RMB-denominated stocks when MSCI China Index moved upwards, while withdrawing big sums when the index dropped (Figure 7). The month-over- month changes in RMB-denominated bonds held by foreign investors maintained a strong positive correlation with the amplitude of fluctuation in the yield on 1Y Chinese central government bond in 2018 (Figure 8).
Figure 9 shows a positive correlation between the growth rate of RMB-denominated assets held by foreign investors and USDCNY exchange rate before 2018, i.e. they tend to increase investments when RMB is strengthening (Figure 9). In 2018, foreign investors continued increasing their holding of RMB-denominated assets despite that RMB weakened sharply. We believe it is due to China's preferential policies for foreign investors at present. Going forward, as foreign investors are able to better hedge against CNY risks, we expect the impact of exchange rate on foreign portfolio investments to weaken.
Chinese government aims to maintain a stable yuan and is committed to exchange rate liberalization so as to make the yuan-denominated assets more attractive to foreign investors. Premier Li Keqiang spoke in the Summer Davos 2018 that China would not resort to competitive devaluation of the yuan.
Cross-border financial capital inflows contribute to a more stable yuan at present, which help to cope with pressure from narrower current account surplus and persistent capital outflows through the errors and omissions. In the long run, net capital inflows through the capital and financial account will push up the RMB real effective exchange rate (Figure 10). We observed that the real effective exchange rates of emerging markets are more likely to be influenced by cross-border capital flows compared with their developed counterparties.
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關鍵字: BOND
