The bonds that bind: Our adversarial sovereign bond habit

In Chinese President Xi Jinping’s recent visit to Serbia, he extolled bonds “forged with blood” between the two countries from NATO’s bombing of Belgrade. 

Yet, it is concerns over future aggression, not past wars, that have the world focused on China. 

The Biden administration, the US Congress, and other governments have raised alarms about China’s military build-up, arguing that Western investors should not be sending money to Chinese companies that are helping to support the People’s Liberation Army (PLA). 

As the UK non-profit Hong Kong Watch explained in a statement before the House of Lords: “China’s strategy of military-civil fusion ensures that unchecked institutional investment could directly counter Britain’s national security interests if British pensions funds and other major players are funding firms in partnership with the Chinese military.”

Direct investment in private Chinese companies supporting the PLA is a serious risk. Yet a far larger pool of Western investments is flowing directly to the state budget of the People’s Republic of China (PRC) through the purchase of Chinese sovereign bonds, funding whatever the PRC budget may prioritise — from Chinese battleships and EV subsidies to concentration camps.

How do sovereign bonds contribute to China's defence spending?

Chinese defence spending, which has doubled since 2015, is paid for from the state budget, which is, in turn, funded by numerous sources, including the issuance of sovereign bonds. 

Those bonds are often passively purchased by global investors based upon their default inclusion in funds that follow key benchmarks, sending vast quantities of money to China with little oversight or awareness of China’s military benefits.

Chinese sovereign bonds are bought by major institutional investors and individual mutual fund owners alike. These investors are rarely making an intentional choice to invest in China. Rather, huge swaths of the market passively base their portfolio composition on aggregated benchmarks. 

The default options on many retirement plans, for instance, are target date plans based upon predetermined mixes from established indexes — one of the risks of what The Wall Street Journal has described as “retirement funds on autopilot”. Indeed, one of the purported benefits of so-called “passive investing” — which now makes up the majority of the market — is its strict adherence to the benchmarks.

Until relatively recently, China’s sovereign bonds were excluded from the global indexes. Then, starting in 2017, a handful of index providers began adding Chinese government bonds to their bond benchmarks. In 2018, MSCI changed its equities index to include Chinese stocks. 

As The Wall Street Journal noted at the time, “In 2018, more than $13.9 trillion (€12.85tr) in investment funds had stock portfolios that mimic the composition of MSCI indexes or used them as performance yardsticks, and nearly all investments by US pension funds in global stocks are benchmarked against MSCI indexes.”

Benchmarks, which are designed to give a representative and diversified slice of the market, have become the unelected arbiters of whether given stocks or bonds are held by all funds that are pegged to the index. 

This decision to add Chinese investments to global benchmarks caused a cascade effect as passive investment funds and others who tied their portfolio to the benchmark followed suit, sending billions of dollars directly to the Chinese state. 

FTSE Russell, a global provider of benchmarks, explained the issue this way: “Fund managers seeking to match, or outperform, benchmark indexes are therefore obliged to increase the weightings in Chinese bonds.”

What is the role of index providers in all of this?

Index providers are for-profit companies, with those profits inextricably linked to the decision of what to include in the benchmarks. 

When MSCI, one of the world’s largest index providers, initially resisted adding Chinese stocks to its benchmark, Beijing threatened to cut off MSCI’s access to critical pricing data in a move described as “business blackmail.” MSCI relented and included the Chinese stocks.

Index providers aren’t motivated only by threats. Bloomberg, Citigroup, and others garnered benefits for adding Chinese bonds to their benchmarks, including receiving a bond settlement license from China. 

That pivot, made on behalf of millions of investors, fundamentally realigned capital toward authoritarian regimes. As The New York Times said at the time about Citigroup’s decision to lead the pack into the Chinese sovereign bond market, “That is a propaganda victory for Beijing, which has struggled to entice foreign investors. For Citigroup, it is a relatively low-risk diplomatic win.”

When Bloomberg and other companies added Chinese bonds to their indexes, it was estimated that Chinese securities would account for just over 5% of Bloomberg’s $53tr (€49tr) Global Aggregates bond index, but those numbers have substantially increased since then. 

Today, the Bloomberg index allocates nearly 10% of its $65 trillion Global Aggregates benchmark to Chinese bonds.

No one is obligated to fund Beijing's war machine

The adversarial bond issue is a market problem with market solutions. Numerous indexes already exclude Chinese bonds (called “ex-China” indexes), but those are limited products that are marketed to clients who must proactively direct their fund managers to include them. Rather, ex-China benchmarks should be the default.

Clients could be permitted, consistent with sanctions and other restrictions, to add those bonds in, but passive investment flows should not be blindly directed to adversarial regimes. Similarly, default options for retirement plans and passive investments should not be funnelled to the Chinese war machine.

Improving the hygiene of financial markets is a necessity, starting with a much deeper discussion about how key decisions — like the inclusion of adversarial bonds in benchmark indexes — impact investors, the global financial system, and the economic security of democratic governments.

No one is obligated to help China fund its war machine. The decision to buy Chinese sovereign bonds should reside with informed investors.

Elaine Dezenski is Senior Director and Head of the Center on Economic and Financial Power at the Foundation for Defense of Democracies (FDD). She was formerly an acting and deputy assistant secretary for policy at the US Department of Homeland Security. Joshua Birenbaum is Deputy Director of the Center on Economic and Financial Power at the FDD.

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