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Emerging Perspectives - China

Our expert team examines the dynamic evolution of the Chinese economy in their blog.

China, today

Will the renminbi rout continue?

Wilfred Wee, Portfolio Manager

Is this the end of the rout in the renminbi or is there further to go? All China Bond Portfolio Manager Wilfred Wee revisits recent developments and considers how Chinese authorities might react going forward.

After the fall, valuations cheap

Increasing US-China trade tensions saw the Chinese renminbi (CNY) depreciate by 8.4% from mid-June to a low of 6.935 against the US dollar in mid-August before recovering over 1.5% to c. 6.80 currently. On some valuation metrics, CNY is cheap, comparable to the levels of late 2016 when concerns over China growth were at their peak (Figure 1). Investors are now wondering where the currency may go from here and what action might Chinese authorities take as the situation develops.

Figure 1: Renminbi value rebased

Source: Bloomberg, 31 January 2014-31 July 2018.

Timeline of US China developments

It has been a noisy few months. The US and China have been engaged in tit-for-tat tactics on trade, unsettling both emerging and most developed markets. This triggered a bout of CNY weakness from the middle of June when the US ratcheted-up trade tensions by formally identifying the first set of Chinese goods to be targeted:

Table 1: Timeline of US-China trade dispute

22 March Trump announces plans to impose tariffs on up to $60bn of Chinese goods.
4 April US Trade Representative (USTR) announces list of $50bn of Chinese goods. China responds in kind.
5 April Trump orders the USTR to consider additional tariffs on $100bn of Chinese goods.
18 - 19 May High-level talks with US Treasury Secretary Steven Mnuchin, Commerce Secretary Wilbur Ross and USTR Robert Lighthizer, and China Vice Premier Liu He; China agrees to significantly increase purchases of US goods to reduce trade imbalances.
29 May White House announces a final tariff list of $50bn of Chinese goods to be revealed by 15 June.
6 June China offers to buy $70bn of US products in exchange for, and conditional upon, the removal of tariffs.
15 June US publishes list of $34bn of Chinese goods at 25% tariffs, $16bn to be reviewed. China quickly follows suit on 16 June, while also backing out of previous agreement to significantly increase purchases of US goods.
18 June Trump threatens 10% tariffs on $200bn of Chinese goods, another $200bn if China retaliates.
6 July US tariffs on $34bn of Chinese goods at 25% take effect. Chinese follow suit.
10 July USTR announces list of $200bn of Chinese goods.
1 August Trump orders USTR to consider raising tariffs on $200bn of Chinese goods from 10% to 25%.
3 August China announces plan to impose tariffs on $60bn of US goods at 5%-25%.
20 August - 5 September USTR holds public hearings on $200bn tariffs.
22-23 August Low level talks between US Treasury Under-Secretary David Malpass and China’s Vice Commerce Minister Wang Shouwen yield no results.
23 August US tariffs on $16bn of Chinese goods at 25% take effect. Chinese follow suit.

 

China’s export and import growth data for July surprised to the upside, despite the tariffs between China and the US kicking-in

The economic impact of the measures on trade so far is not yet obvious. In fact, China’s export and import growth data for July surprised to the upside, despite the tariffs between China and the US kicking-in earlier in the month. While still very early days, China’s trade surplus against the US in July actually increased by 11.3% year-on-year, rather than moderate.

China’s policy responses

Chinese authorities are clearly aware of the risks to the economy from the trade tensions. Alongside the depreciation of the CNY were domestic monetary, regulatory and fiscal policy easing measures aimed at countering potential trade headwinds.

Table 2: Loosening policy measures taken by the Chinese authorities in the second quarter

1 June People’s Bank of China (PBOC) expands Medium Term Lending Facility eligible collateral to include lower rated (AA+ and AA) corporate bonds.
14 June PBOC refrains from following the Fed’s rate hike, relaxes loan quotas for select commercial banks.
24 June PBOC announces 50bps cut in Reserve Requirement Ratio (effective 5 Jul) to support small and medium size enterprises (SME) lending and debt-for-equity swaps.
Late July China’s banking regulator (China Banking and Insurance Regulatory Commission (CBIRC)) encourages banks to better serve SMEs, lower financing costs, and softens restrictions on wealth-management products. State Council meeting calls for accelerated issuance of local government special bonds for infrastructure development, calls for looser fiscal policy.

However, the pace of depreciation then led to concerns that currency weakness could destabilise regional markets and business sentiment. Moreover, the fall had obviously not gone unnoticed in the White House, threatening to aggravate further the standoff between the US and China.

Following verbal suasion against CNY pro-cyclical market behaviour in July, from early August, the authorities explicitly moved to prop up the currency. In early August the 20% reserve requirement for banks selling CNY FX forwards to clients was re-imposed. Similarly, the PBOC Q2 Monetary Policy Committee (MPC) report reiterated that currency weakening is not a tool to address trade frictions.

In recent weeks there have also been reports of a tightening in FX transactions in the free-trade zones (with the aim of increasing the cost of shorting CNY). Meanwhile, on the 24 August, the PBOC confirmed the return of a counter-cyclical factor in setting the daily morning US dollar-renminbi midpoint fix, with the aim of mitigating recent pro-cyclical sentiment on currency depreciation. A line seems to have been drawn in the sand, but for how long?

What next?

In the short term, how the trade situation with the US pans out will have a significant bearing on the CNY. While there could be some agreement before meetings between Trump and Xi at the upcoming Asia-Pacific Economic Cooperation (APEC) and G20 summits in November – we feel this is overly optimistic. More likely in our view is that trade relations remain a long, drawn out and contentious issue, given the strategic issues at play between the two economic super powers. Moreover, we expect anti-Chinese rhetoric to remain a key plank of Trump’s campaigning in the lead up to the US midterm elections in November.

Table 3: Key upcoming dates for US-China trade

5 September Public hearings on $200bn of Chinese goods conclude, final decision possibly a week later.
October - November US tariffs on $200bn of Chinese goods could take effect. Chinese tariffs on $60bn of US goods could take effect.
6 November US midterm elections.
12 - 18 November APEC meeting; Trump and Xi to meet.
30 November - 1 December G20 Summit; Trump and Xi to meet.

 

The official media has markedly toned down its rhetoric and stopped using provocative phrases

China’s reaction going forward

It is undoubtedly in China’s interests to de-escalate current tensions. In recent weeks, Chinese authorities seem to have moved towards more restrained reaction from their earlier robust tit-for-tat retaliations.

The official media has markedly toned down its rhetoric and stopped using provocative phrases like “we will take powerful measures”, which it did in the beginning. The most recent currency measures would also seem to suggest an inclination to not have currency weakness obstruct any potential engagement with the US. Meanwhile, amid unpredictable US trade policy, the Chinese authorities are likely to focus on supporting domestic demand. This may be through conventional monetary policy, but especially likely through upgrading tax and industrial policy.

In recent years, the Chinese economy has rebalanced away from an investment-led growth model towards greater dependence on household consumption and services. Policies to bolster growth in these areas hold the key to achieving broad stable economic growth.

In the medium-to-longer term, the support for CNY ultimately lies in improved productivity and investment prospects in China. To this, the pursuit of stable growth conditions, economic upgrading and transformation, and continued market-oriented reforms are key. We see these remaining well-entrenched in the current Chinese administration.

Conclusion: risk of further depreciation limited

We still see little indication of a quick resolution to the US-China trade spat. However, we think the risk of further CNY depreciation is limited. The destabilising impact of further depreciation on the domestic economy would see the authorities act to support the currency. We can see this in the moves by the authorities to re-apply the counter-cyclical adjustment factor. Moreover, any further significant depreciation will only serve to worsen relations with the US. Indeed, we think China – perhaps taking some comfort from progress made on US-Mexico trade talks – will try to take a more accommodative approach to trade negotiations.

 


 

Tariffs, targets and term limits – where to from here for China?

Roger Mark, Product Specialist and Wilfred Wee, Portfolio Manager

The last couple of weeks have been busy for China watchers – from the announcement of the removal of presidential term limits to Trump’s tariff announcements and the opening of the two-week National People’s Congress (NPC) at the weekend. Here are the key investment takeaways from the last week:

  • Short-term macro stability remains key, but we have greater confidence that we will see a renewed emphasis on structural reforms.
  • Beijing will likely tread carefully on trade; there are real risks of a global trade war, but there is a strategic opportunity to reposition China at the forefront of the global trading system.
  • Political changes should enhance the decision-making progress over the near term, but raise long-term concerns about the future governance of the country.

Short-term macro stability, with a renewed emphasis on structural reforms over the medium term

  • As part of the opening of the two-week session of the NPC, Premier Li Keqiang announced the targets for the year. The key numbers were generally as expected.
    • The growth target was kept at 6.5%, but the removal of the phrase “higher if possible in practice”, suggests greater realism in respect of China’s potential growth. Our nowcast in Chart 1 points to near-term stability around that target, albeit with modest downside risk as a natural result of some of the financial regulatory tightening and industrial capacity cuts. However, Chart 2 shows potential growth continues its moderating trajectory.
    • From a monetary perspective, the inflation target was kept at 3% and quantitative targets for bank lending, total social financing and M2 growth were removed for the first time since 2009, suggesting that resource allocation around monetary policy is graduating from a quantitatively-anchored system to a much more price-based one. Instead, they will be maintained at an “appropriate” level of growth.
    • The formal budget deficit target was lowered to 2.6% from 3% the year before – a signal of the macro tightening bias as the economy moves away from the downside risk in the 2012-2016 period.
    • Finally, the introduction of an unemployment target – linked to both registered and unregistered workers – perhaps reflects the growing importance of employment in ensuring the regime’s legitimacy as China moves away from the transformative high growth era.
  • If the targets pointed to continued focus on short-term stability, there were also announcements relating to more structural changes: further easing of foreign ownership limits in financial services and expansion of foreign access into other sectors such as telecommunications. Moreover, the government also reiterated its commitment to supply-side reforms.
  • Indeed, with this being the first NPC since the 18th Party Congress, the coming days will be carefully watched for new appointments and further details on the structural reform agenda.
  • Economic policy is likely to be placed under the overall responsibility of Liu He – a key ally of President Xi Jinping. He is set to be named vice premier for the economy and financial sector (and according to some reports possibly the next governor of the People’s Bank of China). If the local press is anything to go by, he will head up a highly experienced economics team drawn from senior roles across the country’s financial system.
  • This bodes well for the reform agenda, and while investors have been disappointed with the scope of reforms since the overpromises of the 2013 third plenum of the 18th Party Congress[1], there are reasons for thinking the reform agenda may finally start to accelerate:
    • The focus in recent years was on ensuring stability – first in reaction to macro weaknesses and then in the run-up to the 19th Party Congress. Policy-making can become more ambitious now.
    • Xi has consolidated power significantly – his allies dominate the Politburo and the Central Committee’s Leading Small Groups.
    • This concentration of power together with the trust Xi’s economics team has earned in the run up to the 18th Party Congress, bodes well for more far-reaching decisions in the months ahead.
  • Overall, the policy direction seems to be as it’s been for a number of years: short-term stability, medium-term reform. But this time the reform agenda may actually exceed investor expectations as Liu promised at Davos. We expect greater focus on private sector investment, aimed at innovation and upgrading. This will be a big challenge, but it would be a huge multi-year growth driver.
  • In addition, it looks like there will be further focus on the delivery of improved social (inequality, housing) and environmental governance.

Chart 1:  China GDP nowcast

Econometric modelling is inherently imperfect and not a reliable indicator of future results.

Source: IAM, Haver, Bloomberg as at 28 February 2018. Nowcasting models are used to predict short-term economic dynamics. Nowcasting estimates are based on our proprietary dynamic factor models using third party data. These models are only utilised as part of the team's wider investment analysis.


Chart 2: China finance neutral trend GDP growth vs. actual

Source: IAM, Haver, Bloomberg (as at 28 February 2018)

Trade war risks and a strategic opportunity for China

  • Trump’s tariff announcement coincided with Liu He’s visit to the White House to discuss trade.
  • The steel and aluminium tariffs that Trump announced were ostensibly aimed at China given the national security pretext, despite the impact being much greater on America’s allies and neighbours.
  • Aluminium and steel make up a negligible part of the bilateral trade deficit. This helps to explain the tempered response so far from Beijing. It also arguably reflects China’s self interest in ensuring calm in the global trading system. Trump’s trade policies present a strategic opportunity for China to strengthen trade relationships and links with countries that have traditionally been within the US sphere of influence.
  • However, the Trump administration is unlikely to be finished with its protectionist trade agenda and significant targeted action against China is very likely in the future. The fact that Trump refused to meet Liu He last week speaks volumes – this was a snub aimed at President Xi. The key development we will be monitoring is the recommendations from the US Trade Representative’s investigation under Section 301 of the 1974 Trade Act into intellectual property and technology transfer. On the back of the findings, President Trump has wide discretion to impose significant protectionist measures. It’s hard to make a call on White House policy at the moment, but it is likely some sort of action under section 301 will happen in the coming months. Trump has until August to make an announcement.

The ending of term limits poses concerns over the long term

  • The abolition of term limits of the presidency is simply the latest victory for Xi in his consolidation of power.
  • If Xi stays on as president it is highly likely that he will stay on as General Secretary of the Communist Party beyond the current age limit. (This is where de facto power lies since the end of the Deng era.)
  • The message is thus clear: the era of term limits and age limits are coming to an end. These have served as an effective check on the leadership of the Chinese Communist Party (CCP) since the Deng era to prevent another Mao or stagnation into Soviet-style gerontocracy. The CCP will have to find new norms, or risk the dangers inherent in despotism. The lessons from history are hardly encouraging. Thus while we are encouraged about the shorter-term impact of more effective decision-making on macro-economic reform, the removal of term limits is a negative for the country’s long-term development path.


 

China: shifting focus from financial to environmental health

Mark Evans, Analyst

Libor on the rise

Last month we attended a trip hosted by CICC in China to gain a deeper ‘on the ground’ understanding of the health of the Chinese economy. This was a commodities and macro focussed trip and the third consecutive year we attended.

The government’s reform efforts in reducing excess supply in the economy continue to impress.

Upstream industries are in generally much sounder financial health relative to my first trip in 2016, and the reform focus has clearly pivoted away from financial to environmental health, consistent with remarks over recent months by President Xi. It’s widely expected commodity prices should be supported by reduced supply, although shifting attention to cleaning up the environment may have some unintended consequences for demand.

Xi’s supply side reforms keeping the steel market balanced

To its credit, the government’s ambitious attempts to tackle inefficient steel production and revive profitability is clearly working. My visit to Tangshan, one of China’s big steel producing cities, was testament to that with ‘diamond-effect’ paintwork on Range Rovers, Lamborghinis outside the front of hotels and generally more ‘German metal’ on the road than my previous visits

Aside from these anecdotes, clearly regulatory and financial tightening has forced inefficient producers out of the steel market, with larger and more profitable operators who benefit from economies of scale still producing at near full capacity. Secondly, the government’s core objective of cleaning up the environment is forcing steel mills and other industrialised factories to reinvest in cleaner infrastructure to decrease pollution levels. What I found interesting was how local government officials, far from ignoring Beijing’s call for tighter environmental policy given the negative implications on growth, are implementing a stricter framework than Beijing is pushing for.

For example, we heard that the white smoke emissions from steel mills will not be allowed in Tangshan from November this year, despite the lack of producers with appropriate technology. While measures like this are likely to be watered down, it does highlight the seriousness of local authorities’ environmental conservation efforts. Clearly over tightening risks exist as the government’s focus shifts from quantity to quality of economic growth. However, we gain some comfort from the significant improvement in the coordination of policy and implementation over the last two years, and hence I think any signs of overtightening will be dealt with accordingly.

Tariff anxiety?

Steel producers and other market participants we spoke to weren’t overly concerned with the pick-up in protectionist rhetoric and policy from the US.

The general sense was policies implemented so far were relatively modest in their effect, while any significant tightening would be self-defeating for the US. Admittedly I was a little surprised to see such a relaxed attitude, although we generally concur with the view, as detailed in a blog piece released last week.

Moreover, discussions with a couple of reputable economists also highlighted risks from domestic overtightening far outweighed those of a trade war.

Soft economic activity data

The timing of the Chinese New Year (CNY) makes analysing and interpreting recent soft data prints extremely hard. Chinese demand data generally goes through a seasonal lag following CNY, but it seems to be uncharacteristically slow to recover this year.

At this point and as a result of discussions from the trip, we believe that demand is delayed rather than permanently reduced. We are closely monitoring inventory levels of steel which appear to be moderating and hence provide some comfort that demand has merely been delayed rather than reduced. Weakness should therefore recover during the second quarter. Furthermore, consumer and business confidence surveys continue to point to a healthy macro-backdrop.

Portfolio positioning

Despite slightly reducing some risk in our emerging market debt and emerging market multi-asset strategies before the recent sell-off, we are still positive on the global growth story. China’s contribution to the world economic expansion remains significant, and hence our constructive view on China supports our positive outlook on global growth. In our view, further sell-offs in asset prices relating to a Chinese growth slowdown will provide us with a good opportunity to increase risk at more attractive levels.

In terms of bottom-up positioning, we still hold a long position in the renminbi against other regional peers. The closing interest rate differential with the US (i.e. difference between US and Chinese interest rates) creates some challenges, but overall the balance of payments are in a robust position. Capital outflows remain contained, capital inflows are also gaining traction thanks to recent liberalisation measures and benchmark announcements, while strong global growth is continuing to underpin healthy export growth. Furthermore, we also think renminbi strength is welcomed by the authorities as it helps to contain capital outflow pressures while also assisting in trade negotiations with the US.



 

US Tariffs and their effects on Emerging Market Debt

Mike Hugman, Portfolio manager

Mike Hugman, Emerging Markets Fixed Income Portfolio Manager, argues that this round of actions is now largely announced and reflected in markets and will create opportunities to add risk to portfolios via EM currencies and equities in coming weeks.


Opportunities amid volatility

In recent weeks, the US administration has acted on 2016 election promises to put America first in global trade policy. This has taken two forms – global metals tariffs, and China-specific tariffs relating to technology intellectual property theft. Our baseline is that this will not start a reciprocal trade war, and hence have limited medium-term impact on global growth and markets. A further sell off in risk assets may provide opportunities for investors to add risk. Our asset allocation preferences are emerging market currencies and equities.

Metals tariffs not a major medium-term risk

Global metals tariffs were enacted under section 232 of the 1962 US Trade Expansion Act, citing the need to protect domestic steel production to ensure long-term self-sufficiency and hence national security. The US imported around 36 million tonnes of steel last year, and 6 million tonnes of aluminium, worth around US$40bn. Tariffs proposed were 25% and 10% respectively, representing a small fraction of the value of global trade in those metals. Additionally, the US has granted short-term exemptions to Canada, Mexico, the EU, Australia, South Korea, Argentina and Brazil, which account for about 75-80% of those imports. We expect deals to be reached exempting many kinds of specialist steels, as US industry ex-steel is lobbying hard against these measures. Thus this set of tariffs are not a major medium-term risk.

The case of China

US Trade Representative Lighthizer has been investigating Chinese extraction of US intellectual property under section 301 of the 1977 US Trade Act. Independent estimates have put the long-term cost to the US economy in the range of US$200-400bn. Yesterday, President Trump announced tariffs averaging 25% on a list of goods worth up to $50bn in exports to the US. The final list of goods is yet to be announced, but will come within 15 days, with a 30-day consultation period. The net amount, US$12.5bn, would take around 0.1% off Chinese GDP.

China has responded with mixed rhetoric. A conciliatory speech earlier in the week from Premier Li acknowledging the need to reduce the barriers to foreign investment in China and to end technology transfer demands, reassured markets. This morning, China has announced tariffs of 10-25% on US$3bn worth of US agricultural imports in response to the original section 232 metals tariffs. The announcement carried a stronger tone, warning the US against further actions.

Our base case: largely in the price

The current level of US tariffs, and the response from China, have both been smaller than we expected, given prior analysis. We do not see this as an incentive for China to escalate this trade conflict given the success of ongoing domestic economic reforms, while the US administration has achieved its PR goals. Our base case is therefore that this round of actions is now largely announced and reflected in markets.

In anticipation of this risk weighing on markets in the short term, earlier in the quarter we reduced emerging market currency exposure in our emerging market debt strategies, and equity risk in the emerging market multi asset strategy. However, in our base case of these trade actions remaining contained as outlined above, this will likely create opportunities to add risk to portfolios in those areas in coming weeks.



 

Five investment themes for the ‘Year of the Dog’

By Greg Kuhnert, Wilfred Wee & Michael Power

Chinese New Year is set to arrive on 16 February 2018, leaving behind the Year of the Rooster and ushering in the Year of the Dog. What are the key themes to look out for in the coming canine-related year?


 

Xi embeds his power and reaffirms policy direction

Mark Evans, Analyst, Emerging Market Fixed Income

The nineteenth National Congress of the Chinese Communist Party (the Party) was held from 18 - 24 October, followed by the First Plenary session today (25 October). As expected, President Xi cemented his status as the “Core Leader” of the Party; with “Xi Jinping Thought” having been enshrined into the Constitution. Furthermore, no obvious successor exists within the newly formed Politburo Standing Committee, increasing Xi’s chances of serving past his expected retirement in 2022. Consequently, the significance of other personnel changes was diluted, but from our perspective there will be little to distract President Xi from his policy agenda for the remainder of his term.

At the beginning of the National Congress, Xi’s Work Report laid out the broad plans for the next 30 years. Nevertheless, the market will focus most heavily on what to expect over the next 12 months. In terms of policy direction and momentum, we don’t expect much of a change over the short-to-medium term.

Firstly, Xi has long been considered the most powerful president for decades, so the last week has essentially rubber stamped a process which has been evolving over the last five years and was already well understood. Secondly, and somewhat related, we have seen an impressive shift in the gears of policy implementation over the last 18 months, with a clear focus on better supply side management. This contrasted with previous years where too much emphasis was placed on boosting demand through aggressive credit growth. As a result, the need for drastic policy change is limited at this stage. We therefore expect a continued focus on deleveraging, reducing excess capacity and pollution through SOE shutdowns and tightening controls on the property market to contain overheating risks.

From a portfolio perspective, we remain constructive on the Chinese renminbi. The balance of payments is in surplus as capital outflow pressures have eased significantly. Nevertheless, we still see some evidence of disguised capital outflows and hence do not expect any imminent capital account liberalisation. Trump’s visit to China next month comes as the trade balance between the two countries continues to widen, therefore ongoing currency stability or mild strength will be in China’s best interests.



 

Barriers for entry slowly collapsing in Chinese bonds

Wilfred Wee, Portfolio Manager

Accessing China’s interbank bond market is set to become significantly easier following the implementation of China Hong Kong Bond Connect (CHKBC) in July 2017. CHKBC forms a direct, efficient and transparent platform for offshore institutional investors to access the mainland’s debt market, and will almost certainly be the preferred bond market route for new investors. In our view, CHKBC will inevitably speed up the timing of China’s index inclusion and enable a constant flow of capital from international investors. The Chinese bond market remains a compelling investment opportunity given its yield and diversification benefits, and with operational barriers being broken down further this argument is only strengthened.

What’s changed?

  • CHKBC operates in a similar way to China Hong Kong Stock Connect by using a platform, based in Hong Kong, to create two-way flows between the mainland and abroad. The platform caters for investments in Chinese government, agency and corporate bonds.
  • Operational requirements for institutional investors looking to invest in Chinese bonds are now much less onerous than previous systems. It will now only take approximately three days to set up a trading account and there will be no need to appoint an onshore custodian.
  • Investors can participate in CHKBC using foreign currency and conduct the currency conversion with an approved counterparty in Hong Kong which can access the onshore market. This essentially means that there is no longer any basis risk using CHKBC, unlike previous systems.
  • Market participants can now settle trades at T+2, instead of T+0 or T+1.
  • The initial impact in terms of portfolio flows will probably be limited, but this will likely grow with time as more investors adopt CHKBC as their primary route for onshore bond access.
  • The three previous systems of bond market access will remain (CIBM, QFII and RQFII), yet their importance will likely be superseded with time as new investment vehicles use CHKBC to trade Chinese bonds.
  • International investors only own approximately 1.25% of outstanding Chinese bonds, yet this will likely increase materially over the coming 5-10 years.

Our core EMD funds already have the flexibility to trade in China through either RQFII or CIBM direct. However, given the increased flexibility of CHKBC we can use this method for any future funds or segregated portfolios which have not yet had access to the Chinese bond market.


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