Pictet AM: "Why 2020 could be a milestone year for Asia's fixed income market"

2020 is shaping up to be a milestone year for Asian bond markets.

As Asia’s intra-regional trade and financial links deepen, its individual economies will continue to pivot away from the US and towards China and the renminbi (RMB).

This China-centric monetary zone – or RMB bloc as it has become known – is poised to overtake the euro’s in the coming year to become the world’s biggest currency area after that of the dollar.

This should help the RMB and other Asian currencies regain strength in 2020 and beyond, after spending much of last year nursing wounds from the trade war.

This matters to investors in Asian local currency bonds. That's because currency appreciation has been a key source of return for local currency EM bonds over the past decade, accounting for as much as a quarter of the asset class’s total return.¹

Shared destiny

Wherever investors look, it is clear that, two decades on from the Asian currency crisis, Asia’s economies are forging closer economic, trade and financial ties.

According to McKinsey, 60 per cent of goods traded by Asian economies is intra-regional, as is 59 per cent of foreign direct investment (FDI). Moreover, more than two-thirds of Asia’s investment in start-ups is channelled to companies based in the region.

This has served to reinforce the RMB’s status as Asia’s anchor currency.

Emerging Asian economies are increasingly settling contracts in the Chinese unit, using RMB deposits they accumulate as net exporters to China. Many Asian economies are also considering adding the RMB to the regional foreign reserve buffer fund created after the 1997 crash. If that happens, it would further reduce their reliance on the dollar.

Our calculations, using a currency regression model, show that as much as 19 per cent of movements in Asian currencies can now be attributed to shifts in the RMB, compared with zero in 2006.

The Korean won stands out as the most sensitive of all – our analysis shows some 40 per cent of its movements can be explained by the RMB.²

Although the dollar continues to hold sway, its influence on Asian currencies has shrunk to 81 per cent from a 2008 peak of 90 per cent.

Our analysis shows that the RMB bloc already represents 24.8 per cent of world gross domestic product, just under the euro zone’s 25.6 per cent (see Fig. 1).

Fig. 1 The rise of RMB bloc - Evolution of monetary zones* by major reserve currencies, as % of world GDP

* Monetary zone is estimated as the elasticity-weighted share of 48 economies' GDP, where the elasticity is the reserve currency weight in a given currency using a 2-step Frankel-Wei rolling regression. For more details, see Appendix.
Source: Pictet Asset Management, Refinitiv, CEIC, data covering 01.01.2006 - 31.10.2019

At this rate, it’s only a matter of time before the RMB bloc eclipses the euro zone to become the second largest in the world.

Unfairly punished

The RMB’s growing footprint in the international financial system should provide structural long-term support for the currency.

The unit fell sharply last year, pulling other Asian currencies lower in the process, as concerns about the trade war intensified. Yet according to our fair value models, the RMB is now undervalued by more than 22 per cent against the USD. 

The fundamentals suggest that gap could soon close. 

For a start, China’s economy is in better shape than the headline growth number suggests. While its GDP hit the weakest annual rate in 30 years, we find that the country’s slowdown is in line with the potential growth rate – which takes into account the effect of structural rebalancing and changing demographics – of 6 per cent.

We think the economy would have suffered a more severe downturn if it were not for Beijing’s counter-cyclical policy measures.

Last year's stimulus package including household income tax cuts, infrastructure projects and tax rebate for exports amounted to RMB1.5 trillion, or 1.6 per cent of GDP, the largest since 2009.

We believe the authorities are ready to ease further to support the parts of the economy most vulnerable to the effect of the trade war.

Illustrating the scale of Beijing’s combined monetary and fiscal support, China’s credit impulse, a broad measure of credit and liquidity to the real economy, has swung into positive territory (see Fig. 2).

Fig. 2 Money to the economy - China's credit impulse* and changes in real GDP

* Year-on-year change in total social financing quarterly flow (ex-equity) 
Source: Refinitiv, CEIC, data covering period 01.01.2008 - 31.08.2019

Fears that foreign businesses will leave China en masse have also failed to materialise. The number of foreign-held firms in the country hit an all-time high of 593,000 at end-2018, driven by a record number of new registrations last year. Foreign direct investment into China is stable, growing at the long-term average rate of 3 per cent on the year.

Feeling the chill from the trade war, other Asian countries are also putting up defenses with fiscal stimulus.

At a regional level, emerging Asia is now the world’s fastest growing region, with its economy expanding at just over 6 per cent per year.

Attractive potential

Asia’s resilient economic growth is complemented by weak inflation, which is at its lowest level since 2009.

Taking all this into account, we see brighter long-term prospects for the RMB and Asian currencies.

We expect the Chinese currency to appreciate at least 2 per cent every year over the next five years. This will help lift Asian currencies from their 10-year troughs. We expect them to track the RMB, delivering annual gains of at least 2 per cent through to 2023.

All this reinforces our view that Asia will grab a greater slice of international fixed income investment, developing into a strategic asset class. Investors will have to change their portfolio allocations to reflect Asia’s growing heft.

The 19th century may have belonged to Europe and the 20th to the US. The 21st is poised to be Asia's.

"Asia will grab a greater slice of international fixed income investment as it develops into a strategic asset class."

[1] Source: JP Morgan GBI-EM Index, based on data covering period 31.12.2001 – 30.11.2019
[2] See Appendix

Appendix: Measuring the size of the RMB bloc

• To explore whether a RMB bloc is developing, we examine the elasticity or co-movement of 46 currencies in major economies with the five major reserve currencies in IMF's SDR basket (of which the RMB is one).
• A high co-movement with any of the five reserve currencies indicates that any shock or news that affects that reserve currency's exchange rate also affects the exchange rate of a given currency in our sample (of 46) in a similar way.
• The co-movement can reflect (i) a pegged exchange rate (Hong Kong dollar vs US dollar or Bulgarian leva vs euro) (ii) a managed exchange rate with reference to a basket containing the reserve currencies (Singapore dollar) or (iii) be driven by the market (freely floating currencies).
• The empirical estimation sets the weights of the reserve currencies in representing the changes in each currency. These weights reflect the relative co-movement between a given currency and the major reserve currencies: the higher the co-movement, the higher the weight.
• These weights can then be used to compute currency zones for each reserve currency. A reserve currency zone share of world GDP is estimated as own economy’s share of world GDP plus the elasticity-weighed share of all other economies’ GDPs, i.e. the weights are the elasticities (co-movements) between a given currency and the major reserve currencies.
• The more important the currency zone, the more important this currency should be in the composition of official FX reserves.