Investment focus: Index-eligible or not, China's allure dimmed by yuan fears

Just as China's $10 trillion bond and equity markets appear to be on the cusp of joining global indexes, investors who long sought free access to these assets have started to worry that any returns would be hit by a weakening yuan.
Many were disappointed by MSCI's decision this week to keep China's mainland listed A-shares off its emerging market indexes on the grounds that Beijing needed to make its markets more easily accessible to foreign investors.
But market watchers said the decision, made after months of consultations with investors, at least partly reflected fund managers' unease about allocating more to yuan-denominated assets. Currently, MSCI indexes include only Chinese stocks listed offshore which are freely traded.
China's mainland stocks will almost certainly be added to equity indexes in the coming years, if not months, as will the country's $7 trillion government bond market, the world's third-biggest.
That should bring more capital inflows, especially as foreign holdings of local shares and bonds currently amount to just $180 billion, J. P Morgan calculates.
But the timing is tricky.
An economy growing at its slowest pace in 25 years, falling exports and potential US interest rate rises are seen portending yuan weakness. Memories are still fresh of last August's devaluation, when the yuan fell 2.7 percent against the dollar in one week.
"There is pent-up demand for exposure to China, but we are probably in a period when the world is happy not to hold too much of it," said Kieran Curtis, a bond fund manager at Standard Life Investments.
"You get a pretty decent (bond) yield but people will be reluctant to pile in because of expectations of currency depreciation."
Recent yuan moves give credence to such fears.
Authorities have recently been fixing the official exchange rate at steadily weaker levels, pushing it to five-year lows. That weakness and a surge in outbound investment could also fuel a resumption of last year's huge capital outflows.
The yuan has fallen 8 percent against the dollar since the end of 2013, ceding a quarter of its appreciation since 2005. But against its trading partners' currencies it has fallen 4.3 percent this year, suffering more trade-weighted depreciation than any emerging currency other than the Mexican peso.
Keen to boost the international profile of its markets and currency, Beijing has rushed to make the changes that index providers require, relaxing quota-based investment programmes and clamping down on arbitrary share suspensions.
Bond investors were told last month they would be able to remit money more freely, a move seen as potentially enabling entry to major debt indexes and bringing in at least $155 billion, according to J. P Morgan estimates.
J. P Morgan has already put China on a watchlist for its GBI-EM emerging bond index.
China's government pays 3 percent on its 10-year bonds, far higher than any other country whose currency is in the International Monetary Fund's SDR basket.
But while this is high in the global context, it may seem paltry to emerging debt specialists who earn more than 6 percent on the GBI-EM index on average.
"At this juncture I don't think China will attract material interest...it will be the lowest yielding market in the (GBI-EM) index. Plus the tail risk that they could devalue," said Naveen Kunam, portfolio manager at Allianz Global Investors.
Indeed, non-deliverable forwards (NDFs), derivatives used by investors to lock in future exchange rates, price the yuan at 6.8 per dollar in a year's time versus the spot rate of 6.6.
This is down from January peaks close to 7 but investors planning to buy Chinese assets should use the pullback to add yuan hedges, analysts at Goldman Sachs advise.
Hedging erodes returns: Someone holding a six-month NDF, for example, would pay away roughly 1.2 percent of the yield earned.
Many therefore say they will wait.
"FX risk is something to take into account because with the yield differential being quite low with the US, the FX effect becomes more influential in your investment decision," said PineBridge Investments' portfolio manager Anders Faergeman.
Another 5-10 percent yuan depreciation versus the dollar would get him interested in Chinese bonds, Faergeman added.
Of course not everyone believes yuan weakening is inevitable. China's exports are competitive enough without a devaluation, analysts at asset manager Matthews Asia say.
Sentiment, however, is powerful.
Reuters reported this month that investors inside and outside China were employing various strategies to profit from yuan weakness, including buying Bitcoin and shorting Hong Kong stocks correlated to the exchange rate.
Shanghai shares have fallen almost 20 percent this year and China funds tracked by EPFR Global have seen around $2.5 billion in outflows. That's part of a broader picture of capital flight from Chinese firms and individuals, with May alone seeing $27 billion flee.
Patrick Mange, head of EM strategy at BNP Paribas Investment Partners says big yuan devaluation risks are actually small as China can easily tighten capital controls if needed.
"This risk is in the mind of people, it is a longer-term risk which would impact this market."