China’s bond market is set to play an increasingly important role as Chinese policymakers seek to switch investor emphasis from crisis-prone equity markets to long-term debt markets, the Institute of International Finance (IIF) said.
However, its report came as recent warnings from the International Monetary Fund (IMF) about the build-up of corporate debt from banks in China pointed to “serious problems down the road” and needed to be addressed as a matter of urgency.
The IIF, which speaks on behalf some of the world’s leading financial institutions, said the recent opening of China’s bond market to foreign investors was “undoubtedly a major milestone” in the capital account liberalisation process.
“Despite significant growth over the last five years, the Chinese bond market continues to lag the banking sector as a source of financing,” it said. “One of the reasons has been stringent restrictions on foreign ownership.” However, this is now beginning to change.
Heavy inflows of foreign capital into the market are expected as and when uncertainties surrounding China’s currency ease and as Chinese bonds are included in global indices, the IIF said.
However, regulatory, tax and other barriers to development of the Chinese market still need to be overcome. But the market has huge potential for development as China’s demands for financing grow and as the country diversifies away from its over-heavy reliance on bank financing, it said.
As the Chinese banking sector faces increasing strains and fiscal policy is becoming more accommodative, the shift towards bond financing “has already accelerated”, according to the IIF, which is headed by Tim Adams, the former US Under Secretary for International Affairs at the US Treasury.
ROOM TO GROW
China’s onshore bond market is now the third largest in the world in value terms, having reached around RMB50tr ($8tr) in size or close to 65% of GDP from less than RMB10tr a decade ago, the report points out.
Outstanding bonds in China reached nearly RMB40tr at the end of 2015. Even so, the Chinese market still has “a lot of room to catch up with mature markets” in terms of its size relative to that of the country’s economy, said the IIF.
The Japanese bond market accounts for around 250% of GDP and the US bond market is now over 200% of GDP. “Compared to smaller emerging markets such as Malaysia (around 80% of GDP), the Chinese bond market remains still small as a share of GDP. Even including the offshore bond market, the Chinese bond market has ample room to continue to grow.”
The combination of increasing domestic financial liberalisation in China combined with an ageing population should support continued rapid growth in the bond market as demand from pension funds, life assurance companies and other investors for long term investments grows.
However, the IIF warned there were “significant challenges both on the demand and supply sides”. On the demand side, banks remained dominant and the asset management industry had traditionally been equity-centric while on the supply side the issuer base remained quite narrow.
Meanwhile, the financial regulatory environment in China “remains multilayered and has yet to be simplified”, the report said. “Liquidity is thin beyond treasury bond markets and the average maturity has not increased due to heavy issuance of short-term paper by corporates.
“Given the recent widening in spreads, Chinese policymakers will need to find the right balance between the need to promote better price discovery for both interest rates and credit risks while avoiding disruptive market moves or defaults that could have adverse systemic implications.”
In its latest Global Financial Stability Report in April, Jose Vinals, the head of the IMF’s Director of the Monetary and Capital Markets Department, warned that corporate bank loans potentially at risk in China amounted to almost $1.3tr. These loans could translate into potential bank losses of about 7% of GDP, it said.
Recent defaults on bonds by state-owned enterprises have raised concerns over the implicit government guarantee of prompt and full payment.