China has won widespread praise for its recent efforts to reform its ailing banking sector. But attention is now turning to the country’s domestic bond market – long mooted as potentially the biggest in Asia. Last year, selected foreign issuers were allowed for the first time to sell bonds in the markets – a move which could herald a keenly awaited surge in the market.
No one is as acutely aware of the need for financial sector reform as People’s Bank of China (PBOC) governor Zhou Xiaochuan. The low-key economist has made clear that he wants to open the financial sector to western investment, build robust corporate bond and stock markets and maintain pressure on Chinese banks to clean up their acts and develop into competitive players. More broadly, he wants to end what he calls a “planned economy mindset”.
“It’s a precondition that we develop our [financial] infrastructure to gradually allow the market to play a more important role,” Zhou tells Emerging Markets in a rare interview.
Developing a more vibrant domestic bond market could have major macroeconomic benefits for China. Whether or not China’s financial system becomes more efficient in intermediating China’s large pool of savings and directing it to more productive investments will have major repercussions on long-term growth. The bond market is one of the means by which China is trying to bolster its fragile, bank-reliant financial system and channel the country’s vast pool of savings, largely held in cash, into productive investment.
Crucial move
“The development of the bond market in China is crucial to the country’s financial sector development,” Bill Rhodes, senior vice-chairman of Citigroup, tells Emerging Markets. It is also widely seen as a prerequisite for full convertibility and flotation of the renminbi.
“We’re gradually doing so [reforming] because we need to have a better infrastructure for [convertibility], to improve our foreign exchange market, to introduce some new products, especially those derivatives which can help the clients to hedge the FX risk. We are also improving market mechanism to introduce some [new] market makers,” Zhou says.
As PBOC chief, Zhou has taken strong steps towards creating a real Chinese bond market. Last May, the bank amended rules to let companies raise cash by issuing short-term commercial paper with maturities of a year or less. Firms can also reissue the notes when they come due, which boosts their liquidity. Several dozen Chinese companies, including oil major Sinopec Corp and China Telecom Corp have raised billions on the markets, which is luring institutional investors at a phenomenal rate. The short-term financing bill triggered an explosion of short-term corporate paper issuance.
New issues
Other encouraging signs last year included the first securitizations in China conducted under an official framework – a Rmb3.02 billion securitization of residential mortgages for China Construction Bank, and a Rmb4.2 billion securitization of infrastructure loans for China Development Bank. Thanks to the slashing of more red tape, local banks also started issuing subordinated debt last year.
Zhou says he wants to encourage big corporations with sound profitability to issue corporate bonds first. The main buyers of bonds will be qualified institutional investors (QIIs), as opposed to retail investors. Zhou points out that institutional investors are better able to detect default risks and are better able to handle them when they do arise.
By far the boldest step forward for the Chinese bond market – and the authorities’ will to develop it – was the first renminbi issue by foreign borrowers. The IFC, the World Bank’s private-sector arm, and the Asian Development Bank both launched yuan issues, known as Panda bonds, in the same week in October (See Best Deals, p20).
The ability to issue pandas will prove useful for institutions that already have significant exposure to China’s currency, or that plan to expand their operations on the mainland.
The ADB and IFC were two of the first three institutions granted permission to issue the bonds, alongside Japan Bank for International Cooperation, which has yet to issue. German development bank KfW and the European Investment Bank are also waiting for approval to do similar transactions. The ADB raised Rmb1 billion of 10-year funds in a deal lead managed by Bank of China International (China), while IFC tapped investors for Rmb1.13 billion via leads China International Capital Corp and Citic Securities.
“Our issues in China were different [to our typical funding activities],” IFC vice-president and treasurer Nina Shapiro tells Emerging Markets. “We were branching out into a new market – a huge and growing market. We had to be careful, however, to judge what could sensibly be done at that level.”
Shapiro points out that IFC’s renminbi bond issue is a small but nevertheless key step for China’s capital markets. The hope is that bonds will kick-start the expansion of the non-government bond markets in China and will increase access to capital for private companies.
“The political risks there, in particular, are difficult to know how to handle for any newcomer, though it’s probably smaller than people think,” says Shapiro. But, she says, multilaterals like IFC and ADB are better placed to approach a new market than others. “We can carry out the appraisal, make decisions about conditionality and judge what are reasonable rules for a new market, which the private sector would not do on its own.”
“The bond provides IFC with a unique opportunity to support high-quality domestic companies that need local currency financing,” says IFC director for East Asia and the Pacific, Javed Hamid.
awaiting the Boom
Both ADB and IFC deals were structured to act as a benchmark for future corporate borrowers. Whether they will or not depends on the extent to which China is able to develop what Zhou has called “a financial markets culture”. In this sense, regardless of regulations and reform programmes, the biggest change that needs to take place in China is in its mindset.
Nevertheless, bankers and investors are already singing the praises of market reform. “The bond market is booming this year, and there is a lot of change going on, with the development of corporate bonds and ABS,” says Michael Lin, executive vice-president at Hua An Fund Management in Shanghai. “There is going to be an even brighter future for the bond market than any other financial market in China.”
The bond market has been growing at around 30% a year since 1999, thanks to large volumes of treasury bonds and central bank bill issuance. The total value of debt issued last year came close to Rmb3.7 trillion, an increase of 74.3% over the previous year. Total bonds and bills outstanding stood at Rmb7.07 trillion, a rise of 42% year on year.
The rapidly growing market is attracting very careful attention from global bond investors and international investment banks.
“China is looking to develop its bond markets – they want to do 10,000 issues a year when the market gets going. They have 7 million enterprises. At some point that whole market will expand dramatically,” says Jerome Booth, director of research at Ashmore Investment Management. “That’s the answer for bond investors: there will be a huge flow of capital from the developed world.”
The activity is greatest in the short-term interbank market, the busiest section of China’s debt markets. “The progress has been phenomenal vis-a-vis other markets in Asia, bearing in mind the later start,” says Brian Baker, chief executive of Pimco Investment Management Asia in Singapore. “In common with the rest of Asia and in contrast to the US, China’s bond market has a less developed benchmark yield curve, a less transparent issuing environment, less information disclosure and a lack of derivatives,” says Baker. “Unique to China, you have quota systems in corporate bonds and a multiple regulator environment.”
A lot more work remains to be done. Although the market is liquid at the short end – up to three weeks – it becomes increasingly illiquid thereafter, and rates tend not to be representative, says Stephen Green, senior economist for China at Standard Chartered in Shanghai. This prevents things like the forward market from being properly developed. Illiquidity is partly a result of the fact that banks own and hold most of the long-term paper.
Patience
But with bonds accounting for little more than 1% of corporate financing, investors and regulators alike are clearly on a learning curve – and the market will have to be patient.
“The CSRC [China Securities Regulatory Commission] has gone about reforming the securities market very intelligently,” Kevan Watts, chairman of Merrill Lynch International tells Emerging Markets. “The question is whether they will allow foreign firms in faster to help reform the market.”
Howard Davies, director of the London School of Economics and a former deputy governor of the Bank of England, agrees. “If the bond market is to play a role in economic development, it must reform further,” he says, pointing out, in particular, the need for a ratings structure, to allow for non-guaranteed bonds.
Zhou has previously pointed out that numerous problems remain in developing a corporate bond market, ones for which there might be no easy solutions. First is the fact that China’s high savings rate and abundant liquidity, like many other Asian economies, tends not to encourage bond market development. Moreover, the question remains to what extent China sees foreign participants – especially in the domestic bond market – as desirable.
“We recognize that there are still impediments in both practice and mentality to promoting open markets. But eventually, we will open the domestic bond market to foreign investors, foreign issuers and foreign financial service providers such as credit rating agencies,” Zhou said in a speech last November.
Up to now, however, the biggest obstacle to companies tapping the market has been the need for new approval. All new issues need to be approved by three local bodies, including the State Development Planning Commission (SDPC), which allocate issuance quotas on the basis of regional and sectoral balance. The issuing firm also needs to obtain guarantees from the local government as well as the ministry responsible for its sector. Tussles between various government departments are also partly to blame for the slow pace.
Chinese officials urge the market to be patient. After all, they say, just a few years ago there was hardly any financial system to speak of. “China’s capital markets were created out of nothing,” says securities regulator Shang Fulin.
“In China the credit market is not so mature so market conditions are not yet so perfect,” Zhou tells Emerging Markets. “But all these things we would say are preconditions for developing our financial infrastructure. We are gradually allowing the market to play a more important role.”
Additional reporting by Nick Parsons and Duncan Hooper