In the wake of scandals that have plagued the reputation of China’s bond market in recent weeks, the need for regulators to step away and allow the market to develop more naturally is crucial.
The biggest guilty party is the meddlesome nature of the National Association of Financial Market Institutional Investors (Nafmii), the industry body tasked with overseeing China’s interbank bond market and backed by the central bank.
Since the early days of the market’s development, the regulator has been dictating the pricing offered by underwriters in the secondary market by publishing a pricing guideline on its website.
Every Monday, Nafmii releases reference prices for commercial paper and medium-term notes across various tenors and ratings. The intention is to protect bond underwriters, who might have to take down an entire deal if it doesn’t sell well in the secondary market.
The pricing guidance essentially increases the underwriters’ incentive to underwrite notes that failed to sell in the primary market, as they will be able offload these bonds at a premium of 10 basis points (bp) to 20bp over the secondary market value.
While the rules have worked well during the market’s infancy when participants did not know how to price credits properly, circumstances have now changed especially given that the market is progressing at such a rapid pace.
These rules are one of the causes of the recent emergence of bond market abuse, where the arrests of several dealers and other fixed income personnel at Chinese banks have tainted the reputation of the nation’s capital market. These individuals were accused of selling bonds to investors at prices higher than they paid, pocketing the difference. This was made possible by Nafmii’s rules.
To make matters worse, not only are the underwriters culprits, issuers themselves are equally to be blamed for the fall in China’s bond market credibility. One way they have tried to fool the market is by shopping around until they have managed to obtain the highest credit rating possible, which will in turn improve their cost of funding in Nafmii’s lookup table of bond pricings.
This in turn implies that local rating firms in China have been overly generous to bond issuers. Not exactly the makings of a sound bond market.
This red flag was raised when Nafmii discovered last August that 75 bond issuers in the interbank market saw their ratings elevated, but only seven firms were downgraded from January to June last year. No firms with a rating of ‘AA’, ‘AA-’ or ‘A’ were downgraded. Also, nearly 80% of rating upgrades were for enterprises in energy production, real estate development and other industries that were usually considered susceptible to the economic downturn.
This is a sharp contrast to the practice of global ratings agency Moody’s. Based on the rating firm’s records from 1983 to 2009, downgrades were usually more frequent than upgrades at any rating level.
Given the skyrocketing level of irregularities that exists in China’s capital market, Chinese regulators have a lot of cleaning up to do before it is able to meet international standards and it needs to do it soon before it further loses integrity.
For example the need for Nafmii to provide pricing guidelines to underwriters is becoming less important especially as the market continues to mature and the regulator should instead direct the market towards more fluid, real-time pricing.
To push underwriters closer to market-based pricing, the regulator should cease publishing the prices in the future. As a result, the arbitrage opportunities created by differences by Nafmii’s published prices and existing trading levels will also disappear, leading to greater bond market efficiency.
And as the regulator lets the market dictate the price of new bonds, it is also looking at other pricing-related loopholes which have permitted some market players bag questionable profits.
Nafmii has already acted constructively by unveiling new rules on May 20 that requires underwriters selling short- and medium-length corporate bonds to set prices that are close to those on notes that currently trade in the secondary markets. The rules also ban investors from profiting by buying bonds from underwriters at prices not available to typical retail investors.
The regulator will also restrict trading in the so-called ‘pre-secondary’ market, the gray market that exists between pricing and settlement, from June 1.
The new requirements will bring China’s bond pricing practices closer in line with most liquid debt markets around the globe, though international access will remain restricted for now.
While this will help address bond market pricing discrepancy, this does not help tackle other issues, including lax domestic rating agency practices. Stricter guidelines should be imposed by regulators on before the markets are undermined by a wave of corporate defaults.
Investors should also learn that ratings can never be a substitute of independent analysis and due diligence.
A holistic approach to remedying China’s abused bond market is needed, particularly if Beijing is serious about becoming an international economy.
Just like parents who have to stop spoiling their children, regulators should stop spoon-feeding bond market participants and let them fend for themselves in times of difficulty. That way, they’ll be able to learn from their mistakes and progress to being highly responsible individuals and hopefully contributing to the betterment of China’s capital markets.