In the 12th Five-Year Plan, presented by China’s central bank this week, the People’s Bank of China (PBoC) talked about debt, the need for bankruptcy laws, interest rates and the overreliance on qualitative tools. The agency highlighted the need to diversify investments into equities and bonds, and even dedicated a brief section of the report to the development of the bond market.
Regarding the bond market, by 2015 China hopes to perfect its “bond-issue management system and strengthen the coordination of various departments, interest disclosure requirements and the implementation of supervisory responsibility”. It aims to bolster the market’s infrastructure to encourage innovation and diversification.
These are excellent targets for the bond market as it is poised to grow even more rapidly, but the PBoC did not mention the one solution that should be among the very top priorities for its development: broadening participation to include non-bank investors. And not just at a trickle - but in a real way.
According to Goldman Sachs, commercial banks comprise 70% of secondary trading activity on the country’s interbank bond market, on which 95% of total bond trading volume occurs. ANZ calculates that banks hold 84% of policy banks’ bonds, 60% of government bonds and 35% of corporate bonds, representing the largest group of investors in each category.
By contrast, insurance companies – which are among the largest investors in more developed countries’ bond markets – represent 8%, 5% and 26% of the respective bond categories.
China has long known that this reliance on banks is a real and spiralling problem: with its banks such an integral part of the market, their debt exposure is seismic. This isn’t a problem when the market is strong, but a downturn in the economy (the beginnings of which China is already seeing) makes this exposure riskier.
This will only adds to the concern that banks are being weighted under bad debt. Non-performing loans may double to as much as Rmb3 trillion (US$475.6 billion) in 2012, and that figure will increase as loan books expand. Banks’ loan books are expected to grow 13%-15% this year alone, according to Standard & Poor’s (S&P).
These reasons highlight why banks’ overexposure to the bond market is problematic to themselves and the system. But there’s another reason why an overabundance of banks detracts from the market: their presence squeezes out other investors.
Banks largely have a mandate to buy investment-grade debt. Dealers say that, on particularly popular bonds, banks will buy a large tranche, inflating the price of the bonds, and hold it. That leaves the remainder fought over by insurers, pensions and investment funds. If they can’t get their hands on investment grade debt, what’s left in the market is lower-rated credits and many of these funds do not have the interest or the mandate to invest in these.
It’s key for China to break the cycle of banks shouldering its bond market, by creating a stronger infrastructure that welcomes other investors. Regulators in recent months have already slowly widened participation to include foreign investors through the Qualified Foreign Institutional Investor (QFII) programme, and giving insurance companies more freedom to buy hybrid, convertible and unsecured bonds. But more has to be done to encourage open participation in the market to even out investor types.
There is a need to improve transparency so investors can more clearly understand the risk profile of the debt they buy. Chinese credit rating agencies are far from being considered the most credible sources, and will have to do more to win the trust of investors. Covenants and an understanding of what happens in the event of a default are essential to protect investors. If this happens, they will feel more confident to come to the market.
Another way to encourage non-bank participation is to lift restrictions on who can and cannot invest in specific areas of the market. The mainland bond market is separated into the interbank market – in which non-listed state-owned enterprises and banks issue bonds - and the stock exchange bond market for listed corporates. Large institutional investors are able to buy bonds in both markets, though they are focused on the interbank market, while mutual funds and retail investors are largely confined to the stock exchange market. By tearing down the wall between the two markets investors will have more freedom to buy listed and unlisted bonds. Having the space to more freely participate in both markets will help them diversify their investment portfolio.
China has big ambitions for its bond market in the long term. It has already grown to equal 46% of the country’s total gross domestic product (GDP), according to S&P, and will only continue to expand to rival markets such as the US and Japan, whose bond markets comprise 200%-plus of their GDPs.
To take the market to this next level, and alleviate the problem of systemic risk due to overreliance on banks, China needs to make big strides – not just baby steps – before it’s too late. If this can be achieved by 2015, regulators will have put the market on a good path toward success.