Are foreign investors back to China? The short answer is yes but temporary

Foreign investors’ fading interest in emerging markets could explain the poor return for their asset class es . But China seems to be an outlier as the performance has also been weak notwithstanding higher interest expressed by foreigners, as shown by their growing – albeit still minimal – market share in China’s bond and equity markets. As of Q3 2018, foreigners hold 2.3 % of bonds and 2.6% of equities in China, comparing to 1.3% and 1.2% respectively in January 2016 . This seems surprising given the difficult external environment China is facing, namely the US-led trade war and the increasing divergence in monetary policy between the FED and the PBoC. The key question is whether foreign investors’ keen interest in the China’s financial markets will continue given the tougher upcoming headwinds. We review two key drivers for the recent surg e of portfolio flows into China: a) the portfolio rebalancing by foreign investors due to China’s entry into major indices ; and b) the shelter effect from emerging markets. But we believe both drivers are short-lived. For bonds, the momentum from index inclusion is crucial but could run out of steam if China cannot attract capital beyond passive inflows, which is especially true as the PBoC continues to ease. For equities, the current inflows seem to have gone beyond the passive allocation given the relative small sh are of China in the MSCI index. Yet, the poor performance of the stock market in the last few months could reverse the trend. While the above may imply a slowdown of foreign capital inflows into China in the near future, the disproportionately low foreign participation for the size of China’s economy and financial markets should push international investors to enter China once the external environment improves. China ’ s foreign holding has been low , even comparing with countries that are net creditors, such as Japan (11% in bonds and 30% in equities). All in all, to the question of whether foreigners ’ back to the Chinese bond and equity market is short-lived , the answer should be yes. The rising trade tension and the pressure from FED’s hiking are making it more difficult for China to attract foreign interests beyond the passive flows which has occurred so far. However, down the longer road, we should expect an increase in foreign participation in China’s capital markets as foreign exposure is still very limited compared to China’s size.