The Chinese are renowned for their softly-softly approach to economic development. Policy-makers prefer slow, incremental change. Steps towards modernisation, internationalisation and economic reform are taken gradually.
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The onshore Chinese bond market is a case in point. The market resumed in earnest 30 years ago when the Chinese government began to issue bonds as part of the broader economic reform agenda. Four years later, in 1985, Industrial and Commercial Bank of China launched a Rmb500m ($78.75m) bond; in 1987, the first quasi-corporate bonds were launched; and by 1991, a repo market had been introduced into the treasury bond market.
The Chinese onshore bond market has since developed in size, scale and scope. Recent growth has been dramatic. In 2005, outstanding balances totalled just over Rmb7500bn. In 2011, this figure had nearly tripled, with outstanding balances amounting to more than Rmb21000bn.
Long and narrow
The pace of growth clearly reflects the expansion of the Chinese domestic economy. But it is also testament to a deeper desire by Chinese policy-makers to gradually internationalise their economy and ultimately to make the renminbi a reserve currency.
“The Chinese are committed to internationalising their currency so they need to develop a liquid bond market,” says Philip Poole, global head of macro and investment strategy at HSBC Global Asset Management.
Part of this process involves broadening the market to include a wider range of issuers and investors. At present, issuance is restricted almost exclusively to mainland Chinese institutions and, within that, state-owned and quasi-state-owned borrowers dominate.
The figures speak for themselves. By mid-2011, of the Rmb21000bn of issuance, almost one-third was government bonds. Another third was financial bonds, many of which are controlled by the state. Central bank bills accounted for a further Rmb3000bn.
“The onshore renminbi bond market has developed rapidly over the past five years but it is dominated by government bonds, which account for nearly two-thirds of total issuance,” says Henry Zhao, head of debt capital markets at Chinese securities firm Zhong De Securities.
To many investors, the preponderance of state-related issuance makes the market seems almost homogenous – large in scale, but narrow in focus. “China’s bond market has had two major problems: banks were the dominant investors and the government was the major issuer,” says Yiping Huang, chief economist of emerging Asia at Barclays Capital. “Since the interbank bond market was established in 1997, it has been the largest bond market in China but it has blocked other participants. Also, banks held about 68% of total interbank bonds.”
New dynamic
Times are changing though. The market is opening up and new entrants are emerging. Until recently, for example, China’s 35 regions were only allowed to borrow money for infrastructure projects via bank loans or central authorities. Now they have been allowed to access the bond market directly, launching municipal bonds for specific schemes.
"Local governments used to receive their funding from the Ministry of Finance. Now a few local authorities have permission to issue bonds directly," says Ashish Agrawal, head of rates strategy for non-Japan Asia at Credit Suisse.
“Opening up the bond markets in this way benefits the Chinese regions but it also reduces systemic and liquidity risk in the Chinese banking market,” says Hayden Briscoe, senior vice-president and director of Asia-Pacific fixed income at asset management firm AllianceBernstein.
Corporate bond issuance has been increasing too. There are now five rating agencies operating in China, three of which are associated with Standard & Poor’s, Moody’s and Fitch. The market is now worth more than Rmb4500bn, against Rmb381bn just six years ago. Many believe the development of this credit market is key to China’s economic evolution. At present, much of the issuance, even in the corporate sector, comes from state-owned enterprises, frequently in strategically important sectors such as energy, transportation and national resources.
“The development of debt markets plays an important part in the evolution of financial markets,” says Barclay's Mr Huang. “It helps to create a benchmark yield curve, opens up new financing channels and reduces asset-liability mismatch problems at banks, insurance companies and pension funds. Large corporations and investment projects should be able to raise longer-term funding at a lower cost.”
Towards the end of 2011 however, the converse occurred: corporate credit spreads rose to record highs, even for AAA rated issuers. Curiously too, the widening of spreads was led by quasi-sovereign issues, such as one by the ministry of railways.
“Quasi-sovereign issues, central government-owned and strategically important state-owned enterprises have led the spread widening, defying the flight to quality that typically takes place in stressed markets,” says Zhi Ming Zhang, head of China research at HSBC. “In November, AAA spreads were nearly double their previous highs while spreads for lower-quality issues just edged above old records.”
Corporate momentum
The weakness of corporate bonds was even more noteworthy, as the People’s Bank of China was working hard to inject liquidity into the markets in a valiant attempt to reverse the impact of global risk aversion. The move kept government bond yields down but failed to do the same in the corporate market.
“Despite the drop in government bond yields, domestic corporate yields remain high. An apparent repricing of AAA-rated corporate bonds is under way and this is quite a significant event as some 90% of these issuers are top state-owned enterprises that usually share quasi-sovereign status,” says Mr Zhang.
In some respects, this could indicate a growing maturity within the investment community (much of which, of course, is made up of the banks from which these issuers borrow money in the bilateral loan market). “The days of treating all state-owned enterprises as AAA or nearly identical to the sovereign seem to be over. These enterprises are no longer a general category. Degrees of sovereign support and issuers’ own credit profile have now become more important in analysing issuers’ credit profiles,” explains Mr Zhang.
Encouragingly too, Chinese policy banks have been weathering the credit storm, issuing record volumes and keeping spreads below the 2008 highs. By August 2011, for example, China Development Bank had increased bond issuance by 56%t year on year to nearly Rmb900bn and the Agricultural Development Bank doubled issuance to Rmb300bn. Not only are these figures significant in themselves, they also point to lending lower down the tree. Policy banks are the largest lenders to local government finance vehicles, so their ability to access credit markets with ease is crucial for local economic expansion.
Indeed, it is widely recognised, not just by external institutions but by the Chinese themselves, that healthy capital markets have a vital role to play in economic expansion. The injection of liquidity into the market as global credit conditions tightened highlights this understanding.
“The liquidity injection managed to hold down government bond yields but the real motive was to provide benchmark yield support to revive the onshore corporate credit market,” says Mr Zhang.
Fiscal measures were introduced too. In October 2011, the Ministry of Finance cut the tax on railway bonds’ interest income by 50%, paving the way for a Rmb40bn bond issue by the Ministry of Railways shortly afterwards. In the same month, the China Banking Regulatory Commission gave banks permission to issue bonds, the proceeds of which could be used specifically to lend to small businesses.
“China has bet its future on the private sector and entrepreneurs. That implies that it will create a market-based financial system that supports the companies driving innovation and job creation,” says Andy Rothman, China strategist at Asia-focused broker CLSA. “Over time, private institutions will have to play a bigger role [in China’s bond markets] because all of today’s job creation in China is coming from small and medium-sized private firms. The bond market has to support them over time,” he adds.
Channelling foreign capital
For most non-Chinese investors, the onshore market is frustratingly hard to access. A further sign of Chinese policy-makers’ long-term commitment to the capital markets can be seen in the development of the dim sum market. Launched in Hong Kong in 2007, this offshore market took off at the end of 2009 when the Chinese authorities allowed the renminbi to become a settlement currency for trade in China. From an almost standing start, the market has mushroomed and is now worth about Rmb220bn, a fraction of the size of the onshore sector but a rapidly growing market in its own right.
From early 2010 until the summer of 2011, demand for dim sum bonds was such that yields were chased down to less than 2%, especially low in relation to the onshore market.
“The market was dominated by an excess of demand over supply but things changed in the summer,” says Geoff Lunt, senior product specialist for fixed income at HSBC Hong Kong. “Supply increased more than expected and in September, some offshore investors were forced to repatriate funds. Now yields are averaging 4%.”
The dim sum market is very different from its onshore peer. Not only is it far smaller, it is regulated by the Hong Kong authorities, investors include US and European institutions and issuers range from the Bank of China to McDonald’s. “While the onshore market is dominated by sovereign and quasi-sovereign issuers, only 17% of the offshore market comprises Chinese sovereigns,” says Mr Lunt.
But, even if the two markets appear very different, the rapid development of the dim sum sector over the past two years is widely considered to be part of a longer game plan from the Chinese authorities, which will ultimately lead to the merging of the onshore and offshore markets.
“What the authorities are doing in Hong Kong with the dim sum market is giving foreigners access to renminbi returns without giving them full access to the domestic market. It is a slow process but the Chinese are moving down the development path and at some point, the domestic and offshore market are likely to become one,” says Mr Poole.
Gradual approach
Progress will almost certainly be slow. The authorities do not want to lose control of currency inflows and outflows, and the liberalisation of the onshore market is fraught with danger in this respect, at least in theory. The reality may be less dramatic however, as Mr Agrawal points out. “The Indian government has allowed foreigners to invest up to $15m in domestic bond issues. The money is flowing in but it is not flowing out because investors are worried that if they withdraw funds, they may be unable to reinvest them,” he says.
Over the past few months, the dim sum market has witnessed what happens when investors need to repatriate funds – demand dwindled and spreads widened, in some cases dramatically. This will not have gone unnoticed on the mainland, particularly given the disappointing behaviour of top-rated bonds onshore. Nonetheless, most observers believe that the dim sum market was primarily set up to familiarise investors with the renminbi and to give Chinese policy-makers a real insight into international bond market behaviour.
“The onshore market is likely to experience steady growth over the next five years,” says Tee Choon Hong , regional head of capital markets for north-east Asia at Standard Chartered. “The process of wider use of the renminbi internationally continues to evolve and this allows Chinese policy-makers to observe the effects of each new policy initiative at different stages of this evolution.”
Mr Zhao adds: “The range of investors has been increasing. As well as banks, insurance companies and fund managers are active in the market.”
In March, 2011, the authorities allowed eight more overseas banks to trade in the onshore market, a move widely interpreted as a way of promoting the international use of the renminbi. Six of these were Hong-Kong headquartered institutions. Citibank and Bank of Tokyo-Mitsubishi were also on the list, joining HSBC, Standard Chartered, Deutsche Bank and Singapore’s DBS.
“Since 2010, the Chinese authorities have started gradually to allow non-Chinese institutions to invest in the onshore market. Certain banks have been authorised and central banks are selectively allowed to invest as well,” says Mr Tee.
