China's collateralized debt obligation market is best described as embryonic. With the watershed China Development Bank collateralized loan obligation deal last year, the nascent market has digested one transaction, one asset type (loans) and one product segment (cash). Progress has been hamstrung by the lack of issuance and investment in structured finance products. That in turn has resulted in limited opportunities for market participants to gain experience with CDOs and their key predecessors, such as mortgage-backed securities on the cash side and credit-default swaps on the synthetic side.
While banks and investors remain unfamiliar with CDOs in terms of structural needs, legal requirements, cash-flow dynamics, correlation analysis and pricing, in Fitch Ratings' view, the CDB CLO represents the first official step toward the development of a Chinese CDO market and should pave the way for more CDO issuance this year by CDB or another top-tier Chinese bank. CDO-related issues are addressed by reforms, constraints on supply and demand should loosen. Given current momentum, there will likely be a few transactions per year until the government transitions to a rules-based approach in regulating and approving CDO issuances, following which, the market should grow at an accelerated pace.
Key Challenges
Regulatory controls are perhaps the most important factors limiting the growth of CDOs, as they constrain activity on the supply side as well as the demand side.
On the demand side, the China Banking Regulatory Commission is still in the process of specifying which institutions are allowed to participate in securitizations and whether banks, funds, brokerages, investment companies, insurance companies and branches of foreign banks are allowed to invest in domestic CDO and securitization products.
Meanwhile, the supply of CDO transactions is constrained by the requirement of individual approvals for each transaction. Future transactions may also be subject to amendments to current measures and to multi-ministry approval processes that could cause substantial delays.
The market is also challenged by a range of issues facing the country's bond market which obstruct the issuance, distribution, sales, trading and pricing of CDO products.
On a relative basis, China's bond and equity markets lag behind those of most mature markets and many emerging markets in diversity as well as relative size.
Capitalization of China's stock markets is roughly 40% of the size of its GDP while capitalization of its bond markets is some 30% of GDP. The same figures are 130%/164% for the U.S., 80%/183% for Japan, 161%/93% for Malaysia, 57%/81% for Korea and 56%/35% for India.
The bond market, in particular, is disproportionately small for the size of the economy, now the fifth largest in the world. This is partly due to China's historical reliance on bank credit, which has grown at a rapid pace since 2000 while capital markets have declined or remained stagnant on a relative basis.
Although reliance on bank capital is high across the region, such reliance is most pronounced in China, with bond and equity markets together providing only a quarter of domestic funding needs.
The market's lack of depth and diversity is attributable to the government's tight control over domestic issuers, which resulted in a shrinking corporate bond market and a small universe of corporate issuers--mainly the largest state-owned enterprises. The problem is compounded by rules restricting banks from investing in corporate securities, which leaves a community of smaller, less-well capitalized institutional investors to participate in the corporate bond market. This has resulted in substantially lower liquidity of non-government securities, which have historically shown turnover ratios that are a fraction of those of government paper. This will significantly challenge future transactions aiming to employ domestic corporate assets and will also impede the ability of domestic institutional investors to develop credit skills and credit risk pricing capabilities.
Challenges For Financial Institutions
Chinese banks' ability to execute CDO transactions and to assess and price related risks are challenged by institutional issues including a lack of reliable data on credit quality, defaults, recoveries, recovery timing and loss-given default, which makes it difficult to structure, assess and price transactions using loan assets, i.e. CLOs.
Institutional investors in China also lack experience in assessing and pricing corporate credit risk, due to the fact that most institutional investors hold corporate debt to maturity. Correlation is a new consideration, and correlation trading is essentially non-existent. These problems are compounded by the short supply of home-grown credit skills in China, which results from poor credit training within most banks and other financial institutions.
Additionally, domestic credit ratings in China--the market's credit benchmark--often cluster in one or two rating classes, i.e. AAA or AA, providing insufficient differentiation of credit risk and challenging the banks' ability to develop objective credit views. This has also obstructed the development of credit skills among market participants.
Specifically with regards to CDO expertise, the lack of investing activity in these areas has limited opportunities for domestic market participants to gain or develop related skills and experience. Channels for importation of such skills are also poor: financial institutions have yet to acquire many international staff with the required skills and international banks have yet to receive official approval to operate in the CDO market.
Outlook
Given the challenges, Fitch's outlook for China's CDO market differs substantially from segment to segment. Cash flow CDOs for example, will likely centre on balance sheet transactions, as domestic cash assets are limited in variety and availability and foreign cash assets are restricted by regulation and carry foreign currency risk that will be difficult to mitigate.
Meanwhile, the synthetic market is challenged by the lack of credit-default swap activity in China--on both Chinese and international names--and by the resulting lack of understanding of synthetic structures. Over the medium to longer term however, there could be applications of synthetic technology in the CLO context, as these could offer risk mitigation options not available under cash structures. For example, they could allow originators to avoid a range of legal issues in China if the structure is based offshore.
Structured finance CDOs such as CDOs squared, CDOs of ABS/RMBS/CMBS etc. are not likely, given the dearth of domestic assets and given current government restrictions against such structures.
| Charles Chang |
This week's Learning Curve was written by Charles Chang, director of structured credit for Asia Pacific at Fitch Ratingsin Hong Kong.
