China is on the hunt for a ‘get out of debt’ card.
The country’s Communist government is seeking solutions to an economic slowdown affecting nearly every sector in the market. Its gross domestic product (GDP) growth slowed to 7.8% in the first half of the year, the lowest in three years.
This might still sound like a healthy rate but many of China’s companies and local governments are addicted to rapid growth to keep ahead of costs. The slowdown has left them in trouble, which in turn is causing non-performing loans (NPLs) at banks to mount. China’s local governments owe trillions of renminbi to banks, with no solid way to refinance their loans or fund infrastructure projects.
The country’s bad debts, estimated at Rmb700 bill ion (US$111.4 billion), could double in 2012, according to Barclays. Given that China’s banks are still expanding their loan books – at a rate of 13%-15% this year alone or double the rate of economic growth, according to Standard & Poor’s (S&P) – these NPLs look set to keep rising.
Elsewhere, China’s small- to medium-sized enterprises (SMEs), which account for 80% of the country’s newly created jobs, have long found it difficult to receive loans in a banking sector increasingly worried about bad debts. They are desperate for viable funding avenues to fulfil their growth potential.
Every month that Beijing fails to offer a remedy to these troubles exacerbates the country’s financial problems. Left unsolved, China risks a major credit crisis along the lines of Japan’s problems of the 1990s.
Creating a genuinely viable bond market would go far to fill this void.
China’s bond market is already the world’s third-largest, with Rmb25 trillion (US$3.97 trillion) in debt outstanding. It could easily provide the long-term funding that banks, companies and municipalities need – but not as it stands now.
Fundamental problems ranging from overregulation to poor investor protection hamper the market’s potential. Regulators have striven in recent years to get it up to speed but inefficiencies still sorely need remedying.
Beijing can both improve and expand its bond market by prioritising reforms in three crucial areas: the market’s participants; its regulators; and the legal framework surrounding it.
Accomplishing these changes won’t be easy, and will take extreme cooperation by each of its regulatory bodies. But if Beijing can achieve this, it may be able to solve some financial challenges for good.
Banks can’t have all the fun
The first of these three goals involves expanding China’s investor base away from the country’s banks.
The vast majority of bonds in China are bought by its banks, due in large part to vestigial and nascent pension and asset management industries. ANZ calculates that banks hold 84% of policy bank bonds, 60% of government bonds and 35% of corporate bonds, representing the largest group of investors in each category. And Goldman Sachs estimates that China’s commercial banks account for 70% of secondary trading activity in the interbank bond market, on which more than 95% of total bond trading volume occurs.
It’s a worrying level of dependence: bond markets are meant to provide an alternative source of funding to bank loans, yet in China the two markets are basically one and the same.
“Right now you have banks playing overly major roles in lending and investing, which creates an asset management and liability mismatch,” said Wilson Li, an analyst at Guotai Junan Securities in Shenzhen. “It’s been proven that institutional investors need play a bigger part in the debt market to make it succeed. But right now it’s the banks that dominate the market. That institutional investor class is not the most balanced way of developing the market.”
The overabundance of banks deters other investors. Banks typically buy a large tranche of popular bonds, which inflates their price, and hold them. The remainder is then fought over by insurers, pensions and investment funds.
To develop a healthy bond market, Beijing has to break the banks’ dominance. Key to this is to get other participants to own larger shares of the overall market, but as things stand institutional investors such as trusts, pensions and insurance companies account for less than 30% of investors.
The government is slowly opening the gate for more of these institutions. In July, the China Insurance Regulatory Commission gave insurance companies more freedom to buy hybrid, convertible and unsecured bonds, and regulators have whispered about offering preferential tax measures to encourage pension funds.
But more must be done. In particular, more types of debt need to be issued, and better technology is required to help investors trade these instruments.
“What regulators need to do to get these institutional investors to be larger participants is not just to focus on product innovation like these small- to medium-sized enterprises’ private placements and asset-backed securities, but to focus on the basic infrastructure to make these bonds easily investable and tradable,” says Ping Chew, Greater China head of S&P, noting that incentivisation is key.
Incentives may include regulators eliminating or decreasing taxes on non-banking financial institutions’ accrued interest. Or they can develop liberalised floating interest rates on Shanghai’s interbank offered rate, or Shibor, rather than the People’s Bank of China’s (PBoC) fixed rate, which would help investors understand the market’s pricing. Improving China’s electronic trading systems to encourage more efficient secondary-market trading would also support participation.
“Whatever it takes to get more investors should be regulators’ goals,” says Chew.
Another way to entice investors would be for Beijing to erase the rules that separate the interbank bond market, on which non-listed state-owned enterprises and banks issue bonds, and the stock exchange bond market that is used by listed corporates.
Currently large institutional investors can buy bonds in both markets, but they focus on the interbank market, where the majority of high-grade debt trades, while mutual funds and retail investors are largely confined to the stock exchange market.
By integrating the two, or at least allowing investment funds to buy the debt of listed and unlisted companies, China will encourage more liquidity and a greater diversification of players hunting for new credits to diversify their portfolios.
Lastly, Beijing should cut the red tape that restricts foreigners from investing in the local bond market (see box above).
Far too many chefs
Probably the most difficult part of integrating China’s fragmented bond market will be overcoming the objections of territorial regulators that govern each part of the country’s debt realm.
Three main regulatory bodies manage China’s interbank bond market: the PBoC, which overseas banks’ participation; the National Development and Reform Commission (NDRC), which regulates state-owned enterprises (SOEs); and the National Association of Financial Market Institutional Investors (Nafmii), an independent industry association under the supervision of the PBoC, which regulates the issuance of commercial paper and medium-term notes.
Meanwhile the China Securities and Regulatory Commission (CSRC), led by chairman Guo Shuqing, manages the stock exchange market, and therefore the private corporate bond market.
The respective regulators’ bond approval processes, style of governance and timetables wildly vary. For instance, both the CSRC and NDRC require prior approval for the issuance of corporate bonds and enterprise bonds. The PBoC, which predominantly approves names with a track record, has a more relaxed approval process because it is familiar with issuers’ creditworthiness. But an applicant to the CSRC, NDRC or PBoC may wait months before gaining approval to issue.
In contrast, Nafmii convenes registration meetings once a week to determine whether to accept issuers’ applications based on criteria regarding corporate governance and profitability. That can take just a week.
“The Chinese government has to address that this is one industry with several regulators,” says Philip Li, head of mainland credit rating agency China Chengxi’s Hong Kong bureau. “There should eventually be one bond industry governed by one regulator because several regulators have been causing confusion to the end users, and have created unnecessary power-play issues.”
While this level of regulation had its use during the market’s early development, when handholding helped to guide neophyte issuers and investors, the regulators are jockeying to grab parcels of authority instead of developing a more holistic bond market.
One example emerged in July, when a budget proposal erased the option for municipalities to directly issue debt into the interbank market, governed by the Ministry of Finance. Almost immediately Nafmii announced that municipalities could sell commercial paper and medium-term notes on its market instead (see chart on page 32).
To compound the problem of oversight, Chinese provinces have their own branches of each regulatory agency, and authorities tend to behave differently geography to geography.
“The complexity of the current regulatory landscape and the market environment pose challenges,” Nafmii representatives wrote in an email in response to Asiamoney’s questions. “There is a need for regulatory coordination of their functions and patterns. [Without] intertwined coordination of interests by all parties, it is becoming increasingly difficult.”
While Nafmii did not elaborate as to what regulators can do to simplify their processes, it did voice the need to “gradually improve the co-ordination of government management and the market’s self-management”.
Beijing’s goal must be to create an open and functioning debt market in which investors, rather than regulators, assess the crux of investors’ own risk. The regulators’ role is to guide the market, but investors should have free access to information on a wider range of credits with different risk profiles to determine their own investments. At some point, regulators have to allow the market to take its course.
China could do a lot worse than look to the US as an example. The Securities and Exchange Commission is the only agency to oversee the trillions of US dollars worth of outstanding bonds in the market. Instead of approving each issue as China does, it receives filings and allows investors to do what they will with the credit, as long as appropriate disclosure forms are completed. There is no confusion about which market, which regulator and which territory to register, and the timetable is swift.
It will take years for China to achieve such a market. But Beijing can take steps to standarise issuer application protocols to a single format and synchronise deadline and approval criteria between regulators. Every issuer and investor should know exactly what to expect from the process.
After that the Politburo needs to conduct the most contentious overhaul, bringing the bond market oversight powers of the PBoC, NDRC and Nafmii initially for the interbank market under one body, and eventually add those of the CSRC too.
Attempting to do so will take every political fibre of the country’s incoming leaders, given the vested interests in each regulator, but it is vital to create a vibrant, harmonious and transparent bond market.
The most politically expedient way to do this would likely be to create a new regulatory entity that absorbs all powers. At least then the existing bodies would feel equally disenfranchised.
Demand for defaults
China’s regulators will most likely protest that taking such a step back would endanger investors. Curtailing this valid argument requires a thorough overhaul of the checks and balances that exist to serve investors.
For a start, would-be borrowers need to offer far greater transparency and corporate governance if more participants are to enter the market. And issuers will only agree to that if they are forcibly held accountable for their actions.
This is something that no onshore debt issuer has had to face before. Despite being a bond market of Rmb21.86 trillion in outstanding debts, China has no defaults to speak of. This is not because the entire nation is filled with scrupulous debt-payers.
Instead, China’s banks quietly roll over distressed companies’ loans in times of need at the urging of local regulators. Such tactics have prevented companies including yarn-maker Shandong Helon and solar-panel producer LDK Solar from defaulting on their 2012 and 2014 bonds. But these accounting tricks are also responsible for the bad-debt problems beginning to plague the country. Left unchecked, they will eventually choke China’s loan market and cause a financial crisis.
Such tactics merely encourage a culture of moral hazard while stymieing the development of a mature bond market. Worse, investors and lawyers are left in the dark on what happens when inevitable defaults occur.
“Everybody knows that the bankruptcy and liquidation model is still developing – and while this happens, there is no certainty before it happens what the protocol is,” says Ivan Chung, senior credit analyst at Moody’s. “In Hong Kong you file for bankruptcy, you go to court and there’s an easy path for investors to get their money back. In China, there’s no such certainty. And rules can vary from place to place – in Beijing and Shanghai, the courts behave relatively more efficiently. In places like Hunan, they don’t. There needs to be a standardised mechanism of protecting investors.”
Lawyers explain that, formally, companies must submit a notice of default to their market regulators, who then recommend that the borrowers repay the bond principal, or in drastic cases begin bankruptcy or restructuring procedures. However, the protocol is theoretical at best as the market has never seen a company go through the process.
For a free and functioning market, regulators must allow companies to fail to let everyone – borrowers and investors alike – learn the cost of their mistakes. This is especially relevant given the introduction of the country’s first junk bond market, launched in May, which accommodates companies carrying higher risk than the SOEs and mega-corporates into China’s interbank market.
The easiest way to mitigate these concerns is for Beijing to let ailing companies naturally default, either on loans or bonds, at the next opportunity. This will act as a public message, showcasing every step of the default process.
With a default in hand, market participants have more clout to demand that credit ratings agencies – whose methods for determining creditworthiness are questionable by global standards – step up their game and offer more solid and understandable assessments of companies’ ability to repay their dues.
China has been making strides to improve bond-market transparency. In recent weeks, Nafmii tweaked its process to give the public access to companies’ full registration forms when applying to sell medium- and short-term notes, including any critiques or questions the regulator has regarding the issuer’s health.
This is an improvement on its peer agencies’ practices. The CSRC, the PBoC and NDRC do not publish application documents for bond issuance, only making official approvals public at the end of the application process.
There’s no way regulators can overhaul the bond market’s opaque culture if its own processes are a mystery to investors and issuers. Reform must come from within, and small steps toward the greater goal of open accessibility will add up.
Watch this space
Small steps are the keys to reforming every realm of the market to ensure that it thrives.
China’s onshore bond market is already growing fast. In 1997, it represented less than 5% of GDP. In 2002, it was approximately 24%, and three years later it broached 40%. According to S&P, by the end of 2011 the market equated to 46% of GDP, and just 37% of outstanding loans, which themselves account for more than 100% of GDP.
But these are still low levels compared to neighbouring countries. Malaysia, which has Asia’s fourth-largest bond market, has outstanding bonds equalling 90% of GDP. And the world’s two other largest economies, the US and Japan, claim bond markets that are 200%-plus of their GDPs.
China’s bond market needs to keep growing rapidly if it is to catch up with other liberalising areas of the country’s capital markets. Beijing envisages that the renminbi will be fully convertible by 2015, and Shanghai intends to be a major global financial centre by 2020. The bond market must be a working machine by these deadlines, and regulators will make efforts to see that it expands to accommodate demand.
Dealers, lawyers and market analysts believe that such growth is possible. Estimates of the bond market’s size in five years are 60%-70% of GDP, expanding further to 100% in 10 years’ time. But the same observers caution that the country’s debt market will only rival the sophistication of the US in 20 years, at the earliest.
These are lofty targets for a country that has only allowed SMEs to issue bonds in the past six months, and it is an even further-off goal considering that its own municipalities don’t have free access to issue long-term debt.
Asiamoney recommends that Beijing start with the three concepts presented above. By our measures, the easiest steps are amending the rules to create more transparency into the processing system, as well as eliminating restrictions on different types of issuers and investors. These ultimately take the swish of the government’s pen to achieve.
What will take longer is encouraging greater participation from institutional investors, while minimising the influence of banks. These institutions are accustomed to the market’s traditional behaviour, and old habits die hard. But these too can change, particularly with the help of a unified regulatory body and more assertive alternative market investors who want greater diversity and depth to their investments.
Regardless of the pace of the market’s growth, what matters most is that China adopts good habits now, and maintains the patience to see the changes through.
Do all this correctly, and China will build a bond market that incorporates quality and quantity. That would be an enormous aid to preventing a credit crisis.
