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China hits pause on reform, but not for long

By Addison Gong
12 May 2020

China has made great strides in attracting foreign capital by relaxing stringent rules around access to its markets. But it needs to go further, with experts saying reform should be brought to the top of the agenda once the dust from the Covid-19 outbreak settles. Addison Gong reports.

China has come a long way in opening up its financial markets to international investors over the past couple of years. 

From relaxing restrictions on foreign ownership of securities joint ventures, fund managers, futures companies and life insurance firms, to granting more access to its domestic bond and equity markets, the country’s regulators have been removing one roadblock after another. 

This loosening up was much needed as China’s government looks to transform the country. 

Asia“Most of the opening up measures fell under China’s efforts in replacing an economy which was very much export driven with one that is domestic consumption driven, and attract capital to offset the reductions in trade surplus,” says CG Lai, chief executive at BNP Paribas China in Shanghai. “It’s important for them to build this market to be sustainable in attracting offshore flows.” 

The domestic bond, equity and loan markets will need to be a lot friendlier to cater to the needs of local companies, in particular private companies, along with having a more friendly legal bankruptcy and insolvency framework, Lai adds. 

“If the private companies can thrive, it will be more appealing for investors to bring more money in,” he says. 

After two decades of insisting on minority foreign ownership in securities joint ventures, fund managers, futures companies and life insurance firms, China broke its tight control in 2018. It decided to allow a 51% controlling stake, while promising to remove all caps completely by 2021, before bringing the deadline forward to 2020. 

The phase one trade agreement reached between Washington and Beijing in January, after two years of tariffs and tit-for-tat retaliations, also gave Chinese regulators further impetus to open up. 

For example, the foreign ownership cap for fund managers and securities joint ventures was scrapped on April 1, while a similar change for futures companies took effect on January 1. 

Not so fast 

China is, of course, not as willing to make equally big concessions in other areas of finance. 

Lillian Li, senior credit officer, credit strategy and research, at ratings agency Moody’s in Shanghai, says China may not be as open-minded about relaxations in more strategically important sectors, such as banking and distressed asset management. 


However, there have been some new developments in those areas too — albeit at a slower pace. 

Although foreign banks can set up shop onshore, China has restricted foreign investment in domestic banks for over two decades. But that changed in 2018. 

In August that year, the China Banking and Insurance Regulatory Commission scrapped the 20% foreign shareholding limit by individual investors in domestic banks, together with the collective foreign ownership cap of 25%. This came after the banking industry became a ‘permitted’ category for foreign investment from being a ‘restricted’ group before.

The country also pushed open the distressed bank debt market to US firms as part of the US-China phase one trade deal. Shortly after, Oaktree Capital became the first foreign asset manager to establish a wholly-owned Chinese unit. 

Oaktree previously invested in China through a joint venture with China Cinda Asset Management.  

In the debt market, there was some good news for foreign banks gunning for a share of China’s Rmb103tr ($14.6tr) bond market. 

The National Association of Financial Market Institutional Investors (Nafmii), the regulator of China’s interbank bond market, decided to accept applications from foreign banks for ‘type A’ underwriting licences last year. 

This licence allows the banks to act as lead underwriters for all types of deals from non-financial issuers in the interbank market — a role that was previously exclusive to domestic banks. 

The first two licences were given to BNP Paribas and Deutsche Bank in September 2019. The other applicants were Citi, HSBC, JP Morgan and Standard Chartered. 

BNPP, together with HSBC and StanChart, had until then held the type B licence. This limits banks’ lead underwriting scope to just Panda bonds — or renminbi bonds issued in China by offshore non-financial issuers. 

Deutsche, Citi and JPM held a more junior licence, called the underwriting licence, which allows them to participate as an underwriter, but not the lead underwriter, on deals in the interbank market.

Not there yet 

Having a licence is just the first of many steps that foreign banks have to take to compete for a bigger share of China’s ultra-competitive underwriting market.

Asia“Underwriting licences tend to be given out to only a few players periodically, and it isn’t an easy process to get one,” says Clifford Lee, DBS Bank’s global head of fixed income, in Singapore. “While being able to have a licence is definitely an improvement, we are not there yet in terms of having foreign banks actively engaging local issuers or bringing foreign issuers to the onshore market.” 

For example, foreign banks are yet to lead underwrite a domestic deal on a sole basis. Their involvement is mainly on Panda bonds as well as securitization deals, a big chunk of which are for auto loan asset-backed securities from foreign originators. 

One big roadblock to a bigger underwriting presence could be the fact that even if foreign banks have one of the top licences, they still need to seek the regulators’ blessing every time they want to bring a deal to the market, says a senior debt banker at a foreign firm.  

But BNPP’s Lai says the market access issue is increasingly less of a concern for foreign institutions.

“The challenge for them is not about the licencing, but about how to get their foot on the ground and start making money,” he says. “Even with a licence, there are still many restrictions and complexities on us bringing out more products, which are preventing us from making the businesses profitable. 

“Not being able to make money can be more frustrating than not being allowed into the market,” he adds. 

The restrictions on foreign institutions have made it difficult for them to compete with the domestic players, says Augusto King, head of capital markets group at MUFG Securities Asia in Hong Kong. 

“Chinese regulators don’t need to be too worried, because even if they decide to open the market up further like Japan, Malaysia and Thailand, it will not disrupt the market and disadvantage local banks and securities companies because we simply cannot compete head-on with them,” King says. 

He cites the example of MUFG’s home market Japan, which, despite its longer history of opening up, is still dominated by the Japanese banks when it comes to domestic bond underwriting. 

“What we could do in the China market is to service our multinational clients that have operations in China, and that’s how we see ourselves competing, even with a licence,” he says. 

MUFG, together with Mizuho, was given the underwriting licence in September last year. 

For now, issuers are not looking at China’s bond market for funding arbitrage, given restrictions on repatriating the proceeds offshore. 

“The attractiveness of the Panda bond market is really having that capability for our international clients to raise medium-term funding for their operations in China and to expand their businesses in China,” King adds. 

“And opening up more foreign bank participation means that we can then bring more clients to China, if they know they can secure that long-term funding which the bank market cannot provide them.”

Given the ample liquidity onshore, more local currency funding is expected, says DBS’s Lee. “When there is liquidity, bringing in more foreign issuers is an imminent possibility with just a change of regulations,” he adds. 

“A clearer and broader set of guidelines on the types of foreign issuers allowed onshore and the easing up of regulations in bringing the bond proceeds offshore can help this market grow even faster.” 

Onshore bankers tell GlobalCapital that they are, for now, not concerned about the increasing presence of foreign firms. Even with the supportive policies, it would likely take years, if not decades, before international banks can develop their own domestic client base and build a competitive local franchise in a market that has been functioning well without them, they say. 

Far from a credit play  

Bringing foreign issuers into China is one concern. Another longstanding concern for the country remains how to draw sustainable foreign capital inflows as its economy moderates. 

To help attract greater flows into the domestic bond market, Beijing launched Bond Connect in July 2017. This allows a broader group of overseas investors to access all tradeable bonds in the China interbank bond market (CIBM) directly through Hong Kong’s market infrastructure, under the so-called ‘northbound trading’ link. 

The scheme was considered a game changer and a gateway to China. 

The appeal was obvious. The connect provides investors easy and quota-free access to the mainland. This was in stark contrast to other much more restrictive schemes such as the qualified foreign institutional investor (QFII), renminbi-denominated RQFII and CIBM Direct. The limits on QFII and RQFII quotas have since been scrapped. 

But despite attempts from regulators to encourage overseas investment to help offset increasing outflows and support the renminbi, money is yet to trickle through to where it is most needed — the credit market. 

“The Bond Connect and the removal of QFII/RQFII quota limits have made it easier for investors to go in and out of the onshore market,” says DBS’s Lee. “It is a necessary infrastructure improvement and a step in the right direction, but there are a few more steps for us to get through.” 

The larger issue at hand, he adds, is that foreign investors’ involvement in the onshore market is primarily in government bonds, policy bank bonds and some negotiable certificates of deposit (NCDs). 

“It’s still more of a rates play than a credit one, [and] there remain challenges for it to become a credit play,” says Lee.

AsiaThere are numerous problems. One is a lack of trust in onshore ratings. The other is that the way hedges and swaps can be done onshore remain varied from how they can be done offshore, Lee says. 

“These parts of the infrastructure will continue to be a work-in-progress,” he adds. “It takes time for investors to go down the credit curve and the market needs more participants to help expedite this, [and] allowing more foreign financial institutions to operate in China can help bring this about sooner.”

Another concern is the type of investors buying Chinese bonds. Institutional investor participation, for one, is still minimal, despite the regulators’ efforts. 

Chi Lo, a senior economist at BNP Paribas Asset Management in Hong Kong, says official institutions remain the biggest buyers of onshore bonds held by foreigners. 

“Throughout the trade war and the virus outbreak, foreign inflows into the Chinese bond market have not stopped at all. It shows that the world is still buying the Chinese story, despite the negative narratives,” he says. 

“It is also because, unlike the equities market, the majority of the capital inflows to Chinese bonds are still coming from central banks and official institutions.”

Chinese bonds offer compelling yields compared to the US and other developed markets, but Lo says Chinese government bonds are still preferred in the short term.

“I wouldn’t be looking at credit at this point, because there will be more defaults coming out of this slowing economy, especially with the coronavirus,” he adds. 

What’s holding back other international investors from jumping into the mainland’s debt market? 

Better discipline 

One of the problems for credit investors has been the lack of trust in onshore ratings. 

Domestic rating agencies have long been criticised for not providing some much-needed credit differentiation for foreign investors buying onshore debt. Over 70% of the issuers are rated AA, AA+ or AAA onshore. 

Some also believe that a crowded domestic ratings market, where eight major agencies are fighting for the same pie, may have led ratings standards to slip. 

Credit investors may take comfort from the fact that S&P Global (China) Ratings, wholly-owned by S&P Global Ratings, obtained an onshore licence in early 2019, before rating its first domestic issuer in July. 

Moody’s and Fitch have also made applications to start rating onshore deals independently. 

The hope is that these agencies will introduce more discipline in the domestic ratings market and produce high quality research. 

This will, in turn, help not only foreign but also local investors navigate the challenging landscape of investing in Chinese bonds. 

“Now that foreign institutions are allowed to rate bonds in the interbank market, the level of global consistency they will be providing should give more comfort to foreign investors,” says Chris Pigott, head of Hong Kong ETF services at Brown Brothers Harriman in Hong Kong.

Reform will continue after Covid-19 

China’s story remains an attractive one, despite all the challenges facing international banks and investors over access. But the country’s fast pace of reform was dealt a blow this year, when the Covid-19 outbreak hit the country hard. 

Declared a pandemic, the coronavirus was first reported in China in December 2019. It rapidly spread through the country early this year, before taking a toll on other Asian countries, and then the rest of the world. 

The disease has forced China to refocus on growth protection, with opening up inevitably taking a back seat. 

AsiaBut market participants speaking to GlobalCapital believe the impact from the coronavirus will be short lived. As soon as productivity increases and growth stabilises, Beijing will refocus its efforts on broadening access to its financial markets to those overseas. 

“It seems as though the commitment to further opening up the financial markets is still there and there are still very good economic reasons why China would want to do so,” says Michael Taylor, managing director, credit strategy and research, at Moody’s in Singapore. “While there might be bit of a temporary interruption, we expect to see this trend continuing over the longer term.” 

Chris Pigott, head of Hong Kong ETF services at Brown Brothers Harriman, says he expects China to accelerate its opening up agenda, “just like it has done during challenging times in the past”. 

“China will look for opportunity to continue to drive forward the regulatory agenda around opening up the capital markets,” he says. 

The policymakers also appear to be conveying a similar message. 

As the pandemic came more under control in March, various Chinese officials, including premier Li Keqiang, reiterated the government’s intent to further open up despite external and internal challenges. 

China is a huge market that will only get bigger. It offers an opportunity that no one can afford to miss, says Clifford Lee, DBS Bank’s global head of fixed income. 

“It is after all the opening up of a gargantuan market to the rest of the world, and inevitably therein lie hurdles that would require a longer time to solve,” he adds. “But we believe there is the political will to get it done — it may just take longer than what the market would like.” 

That confidence from foreign firms — that China will carry on with financial market reform — is key. 

But while China can open up its financial markets to the world, and the investment scope for international fund managers to include Chinese assets in their portfolios, that doesn’t necessarily mean the money will come in, reckons Chi Lo, a senior economist at BNP Paribas Asset Management. 

“It boils down to foreign confidence in China’s growth outlook, which then boils down to their confidence on whether Beijing is steering the policies towards the direction that will lead to sustainable economic environment,” he says. 

“Investors who come into China and increase their exposure in China must be buying into an improvement picture. If someone doesn’t have that confidence, then I don’t think the Chinese market is for them.”   GC

Still restrictive

The unfortunate reality is that, even when including government bonds, foreign participation makes up just a tiny fraction of the onshore bond market — at just over 2% last year. 

In comparison, foreign bond holding stood at 12% for Japan, 24% for Malaysia and 39% for Indonesia. 

MUFG’s King points to accessibility as the primary reason of the low participation, saying that a lot of investors find investing in China rather complicated. 

“You have the Bond Connect which has a different system of settlement, and then there is the quota system — there’s just a lot to get their heads around,” he says, adding that there is a lot of explanation that foreign banks need to provide investors. “It is good to have the platforms, but the process is still considered quite complex compared to what investors can do elsewhere.” 

BNPP AM’s Lo says that while all the relaxation measures are loosening foreign ownership of Chinese assets and improving liquidity, “ultimately there’s still control”. 

“For example, the Stock Connect is a very free trading mechanism for foreign investors to buy Chinese A-shares, but investors can only do that through Hong Kong,” he says. “And that’s just one restriction.” 

In addition to the complicated schemes and operational hurdles, the fact that there is not much secondary liquidity in China’s bond market is denting investor appetite. From the issuers’ perspective, it remains difficult to move the proceeds offshore. 

“China is trying, but they are trying in the context of still retaining certain level of control, which does make investors hesitate to come in proactively,” MUFG’s King says, adding that it makes sense for the government to simplify inflows and outflows so there will be more liquidity coming into China. 

Despite inflow improvements in recent years, many do not see further loosening on outflows happen in the near term. 

“China is very cautious about capital outflow, having lost $1tr of foreign reserves within a year back in 2015, and the renminbi is yet to become an international currency,” says a senior banker onshore. 

“In the process for the renminbi to become a key international currency, China is still at a stage where it needs to have enough foreign currency to create confidence in its own currency,” he adds. “I don’t see that changing in the next few years.”   GC

By Addison Gong
12 May 2020