Foreign investors now have multiple ways of getting access to China’s bond market. The qualified foreign institutional investor (QFII) scheme, launched in 2002, gave major funds access after a lengthy approval process.
Renminbi QFII, a similar scheme for those who had the ability to raise the currency offshore, came nine years later.
With CIBM Direct following in early 2016, and the headline-grabbing Bond Connect link launching in the middle of 2017, there has been no better time to be a foreign bond investor in China’s capital markets.
Chinese regulators have also made efforts to bring more issuers to the market. The Panda bond market, which refers to foreign issuance in the country’s onshore renminbi bond market, remains tiny: the Rmb96.5bn sold in 2018 was just 0.22% of total onshore renminbi issuance.
However, the People’s Bank of China, the central bank, has tried to move things along. In 2018, it issued two sets of guidelines for issuers, finally giving bankers something that they had been demanding for years.
What exactly is the purpose of all this? The conventional answer is that China’s regulators are trying to ensure domestic issuers and investors learn something from foreign players.
There is no doubt some truth to that. Foreign credit rating agencies have also been welcomed with open arms. Foreign banks can now take majority control of their onshore securities houses.
But that explanation belies the minimal impact foreign institutions have had on the bond market so far.
Foreign investor interest still narrowly centres on Chinese government bonds (CGBs) and policy bank bonds, two low risk assets that offer little room for foreigners to prove their superior credit analysis skills. These two “boring assets” — as onshore bankers call them — took up 96.87% of foreign investors’ Rmb1.51tr onshore bond holding in 2018, data from the China Central Depository and Clearing (CCDC) shows.
Market participants say it is likely that as foreign rating agencies begin to rate more deals — addressing the concerns of some investors who feel Chinese credits are constantly over-rated in their domestic market — more money will indeed move down the credit curve.
But for now, foreign investors are sticking to the top of the curve and foreign issuers are having minimal impact.
In reality, the big leap forward in China’s credit market is likely to come from a government increasingly willing to watch issuers default on their bonds. And when it comes to learning lessons from one another, Chinese market participants have just as much to teach their foreign counterparts.
The default option
Does China’s bond market adequately price risk? This question has plagued bankers and analysts for years. Their doubts have come from two sources: the tendency of domestic rating agencies to give almost every deal a rating of AA or above, and a distinct lack of defaults in the onshore renminbi bond market.
Between 2015 and 2017, there were just 116 defaults with a total value of Rmb84.6bn.
However, in 2018 alone, there were 124 default cases with a total value of Rmb120.6bn, Wind data shows.
These problems are being addressed rapidly. In March 2018, the National Association of Financial Market Institutional Investors (Nafmii) said it was going to allow foreign rating agencies to enter the market.
Although Fitch, Moody’s, and S&P Global Ratings, the big three international credit rating agencies, all submitted applications by August last year, only S&P has been granted permission to rate Chinese domestic deals so far.
The government has also taken a more liberal approach with bond defaults. The number of corporate bond default cases surged to 124 in 2018 from 35 in 2017, Wind data shows.
The value of defaulted bonds was almost four times the previous year’s Rmb33.7bn. That is still a tiny portion of China’s Rmb87tr domestic bond market, but it is clearly sending a signal to investors.
It is not just the size and number of defaults that is rising, but also the diversity of defaulting companies. Last year, private companies such as Wintime Energy and Henan Zhongpin Food made up around 90% of the defaults. This year, however, default cases have shown that being state-backed does not mean being risk-free.
Qinghai Provincial Investment Group, a local government financing vehicle, caught investors off guard when it missed an $11 million interest payment on a $300 million offshore bond in late February, the first time a state-owned Chinese company has done so for 20 years. (It later made good on the payment.)
As a result, the long-lasting belief that the government, local or central, is a safety net for the market is crumbling. Those investors who have previously been lenient to issuers have become more demanding, insisting on cross-default clauses, turning down debt extensions and being quicker to pounce on issuers when they miss a debt payment.
“There are more types of losses investors can face,” says Liu Qingchuan, managing director at China International Capital Corporation (CICC).
“As a result, previously, investors might think it is alright if the issuer postpones payments a little bit, as long as both sides were in good communication. Now they are unlikely to grant the issuers such special treatment, which shows signs of an increasingly maturing market.”
This has been accompanied by a rise in issuers skipping the call dates on their perpetual bonds, instead swallowing a large step-up in funding costs to avoid having to pay back the principal.
That may not be welcomed by investors, but in the long run it will help ensure that non-call risk is priced correctly in the domestic market.
The same is true of rising defaults more generally. They may be bad news in the short term but in the long run, they will help the market develop. That, at least, is the government’s hope.
“There has been a general trend that China wants to allow more defaults in the market and let the pricing be more market-driven, reducing implicit and contingent support,” says Stephen Chang, executive vice president and portfolio manager at Pimco.
Angus To, deputy head of research at ICBC International, says defaults would continue onshore as the Chinese government is still deepening the supply side reform.
“The economy is still facing an over-capacity issue and that’s why some of the companies in specific industries are facing fierce competitions,” says To.
“Letting some of the less efficient companies fail is part of the supply-side reform in our view. It will help to fade out some of the bad companies and curb over-capacity.”
That will help develop the market. Since rising defaults should lead to more proper pricing of risks, helping to differentiate risk profiles of enterprises, they will also lead to demand for more credit products to hedge the risks, says To.
Wilfred Wee, portfolio manager at Investec Asset Management, says: “Ultimately, investors want to see much more credit differentiation, in terms of pricing and in ratings, that reflect underlying true credit fundamentals.”
On the question of defaults, however, onshore bankers and regulators pinpoint deeper structural and trust issues.
“When we rate private companies, we have no alternative but to rely on the fake financial statements they provide us,” says an executive at one of the big three credit rating agencies.
“These materials have been stamped and vowed to be accurate by the companies, but some of them turned out to be fake. In some ways, rising defaults may actually start to reveal some level of dishonesty in the system.
“Now the government has let some companies default, investors will hopefully stop treating local governments as a safety net and do some actual research into the companies, which they should.”
This is urgently needed. State-owned banks, hamstrung by tougher rules on shadow lending and conscious of keeping their non-performing loans down, are reluctant to increase their lending to private companies. Nor are they confident of their ability to really identify where the risks lie.
“To be honest, we simply do not have the time to do research on those private companies,” says a senior DCM banker at a state-owned bank. “Sure, we can offer them loans, but that’s far from enough. To really save the private sector, you need to mobilise the public and private fund management companies. They are the ones that have the time to look into the private sector.”
Surely, this is where foreign institutions can help? Foreign banks, eager to further their relationships with the all-important Chinese client base, can increase their lending to private companies.
Foreign rating agencies can help develop an awareness of the vast differences in credit risk among Chinese issuers.
Perhaps. But before they make a major contribution to China’s capital market, foreign players still have a few things to learn themselves.
Guanxi: old tradition renewed
An intriguing observation during talks with onshore DCM bankers, younger and older ones alike, is their insistence that unless international players do things “the Chinese way,” they will be unlikely to truly enjoy what China has to offer.
Many of them cite the Panda bond market as an example.
Although the Panda bond market has grown from a mere Rmb12.5bn in 2015 to Rmb96.5bn in 2018, at least half of those deals were issued by red-chip companies, a term that refers to Chinese companies incorporated in Hong Kong.
In the past six months, regulators have made efforts to standardise the Panda bond market. Two sets of formal Panda bond rules were published last September and this January. Three foreign banks, HSBC, Standard Chartered, and BNP Paribas, have received permission to be lead underwriters of Panda bonds.
Does this mean the stage is set for genuine foreign issuers and investors?
No. They still need to develop their guanxi, or network of relationships with the key stakeholders in China’s market. Relationships are important everywhere but local bankers say that in China, they are paramount.
“Being the lead underwriter of Panda bonds requires a significant amount of guanxi,” says a senior DCM banker at a state-owned bank that is the lead underwriter of many Panda deals. “We have specific departments whose sole job is to communicate with the regulators, essentially, to maintain good guanxi with them. Foreign banks do not have and do not want to nurture these guanxi.”
Similar resistance exists to what onshore bankers call “real” Panda issuers, those companies that are genuine foreign issuers rather than red-chip companies.
“These genuine Panda issuers pay unnecessary attention to certain things,” says a second DCM banker at another bank that is also on most Panda deals.
“For example, one time we had an international client. They have issued Pandas before, multiple times, but for some reason the regulators asked them to disclose not only their operation situation in Asia but specifically in China.
“If it is a red-chip company, they will submit the additional document on that same afternoon, no questions asked,” he continues, becoming visibly annoyed.
“But the client asked us to go ask the regulators a list of questions. Will they require more documents? What’s the reason that they require additional information? Why did they require additional information this time but not the time before? What could have taken one day to settle took weeks. What they don’t understand is that maybe that specific person in charge of their deal just had a bad day and wanted more documents.”
CICC’s Liu, however, says at least having foreign banks on the underwriting teams may attract more foreign issuers.
“Most of the onshore financial institutions have limited ability to attract genuine foreign Panda issuers,” he says. “Foreign banks, however, have served international companies for years. Naturally, they are in a better position to persuade their clients to issue bonds in China.”
All market participants GlobalCapital Asia talked to agree that 2019 will be a year of surging foreign investment, despite fears over the US-China trade war and slowing economic growth.
Some foreign investors, however, seem to be more ambitious than domestic bankers.
“Fixed income investors care a lot more about balance sheet strength,” says Wee at Investec. “China’s sovereign balance sheet – foreign reserves, net international investment position — is strong,”
“While bond index inclusion was a milestone, it would be a pity if market opening measures stopped there,” he adds. “I hope to see financial reforms, and the capital account opening, continue. China has the capacity to be a leader in the world financial order.”
Onshore bankers imagine a more gradual process of increased foreign participation. But they too say that changes are happening. By the end of 2018, international investors held about 8% of all Chinese government bonds (CGBs) — but they bought half of the CGBs issued in 2018, CICC’s Liu says.
Foreign investors’ risk appetite may gradually increase and they will look beyond Chinese government bonds and policy bank bonds.
“Now they’ve bought half of the CGBs and the rate of CGBs is likely to go down further,” says CICC’s Liu. “They [international investors] can’t have a low risk-appetite forever, right?”
Others believe foreign investors’ attitude towards China may be more proactive than Liu expects, thanks in part to the rising inclusion of Chinese bonds in major global indices.
Bloomberg has started the 20-month three-phase period to include 363 Chinese securities in its $54tr Bloomberg Barclays Global Aggregate Index.
This follows the inclusion of Chinese A-shares in the MSCI’s emerging market index. Market analysts estimate the foreign inflow generated by both index inclusions will be somewhere around $140bn next year alone.
“Foreign investors will need to shore up RMB assets,” says a director of bond issuance at a state-owned bank. “More importantly, index inclusion will force them to care about China.”
As if they didn’t care already.