Chinese bond market on long and winding road to maturity

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Despite the strides China is making in the development of its $2.7 trillion government bond market, it remains structurally inefficient, thanks to meagre trading volume in an asset class strangled by the country’s fixed interest rate regime. Calls are growing for greater efforts to develop the government and corporate bond market structure in a bid to boost the efficiency of savings and non-bank financing.

China’s leaders have acknowledged if they are to rebalance the economy, the country’s vast savings must be put to work productively.

The iron-grip over interest rates has to be relaxed for there to be any hope of boosting domestic consumption and reining-in overinvestment. Current deposit rates mean savers earn virtually nothing after inflation.

The long-term goal is to eliminate capital controls and open up its economy to foreign investment, and a deep, liquid bond market is a pre-requisite that would help prevent the resulting capital inflows and outflows from causing interest rate volatility.

A properly functioning government bond market with plenty of liquidity can make the market a benchmark for risk-free rates and for pricing instruments in other markets.

Development has proceeded in fits and starts, with China issuing its first debt in 1950, just one year after the People’s Republic was founded, but terminated the programme before the decade was out. Issuance resumed in 1981, but there was no secondary market until 1990 when the country’s first stock exchanges were established in Shanghai and Shenzhen.

Today it is one of the world’s largest after the US and Japan, but activity is limited, particularly in the secondary market due to relatively low liquidity reflected in the lack of availability of data. Daily data, which is essential to the efficient functioning of the market, has only really been available for four years but is increasing rapidly.

According to a May 2013 report by the Federal Reserve Bank of New York, the Chinese government bond market lacks efficiency, despite being one the largest in the world.

The study finds that yields are moved by some macroeconomic data, such as China’s producer price index (PPI) and manufacturing purchasing managers’ index (PMI), but secondary-market price discovery is found wanting, by and large, with yields failing to adjust to new market information given limited trading.

Daily trading volume in the interbank depository market – including treasury, policy-bank bonds, central bank notes and non-financial (enterprise) bonds issued by government-affiliated institutions and companies – accounts for more than 90% of the bond market and averaged RMB282 billion ($46 billion) in the first five months of this year, according to China Central Depository and Clearing.

However, volume plunged in June after a crackdown on profit skimming and a liquidity crunch in the interbank lending market. This compares with an average daily volume of $550 billion and rising in the same period in the US market, according to New York Fed data.

At $1.38 trillion, China’s corporate bond market rivals the government treasury debt market at $1.3 trillion, and is on course to overtake US corporate debt outstanding in 2015 as the government encourages firms to issue bonds in an effort to tackle the economy’s overdependence on bank lending, according to Standard & Poor’s (S&P).

 
Source: Asian Development Bank

The agency expects Chinese companies’ debt requirement to hit $18 trillion by the end of 2017, accounting for a third of the forecast $53 trillion in new debt and refinancing needs of global companies in the next five years.

Despite the massive growth of China’s sovereign and corporate bond market during the past decade, Rees Kam, senior strategist at SJS Markets in Hong Kong, says: “The bond market is not as well developed as in some western countries. One of the biggest problems limiting its growth is that ordinary investors don’t really have access. Most of the bond market in China is only open to banks, insurance companies and other institutional investors.”

“China needs to develop a retail bond market to provide investors with an alternative to placing their money on deposit with the banks or investing in opaque wealth management products sold by banks.”

Kam adds: “China in general still lacks viable investment choices. More than 90% of Chinese savings are in the banking system compared to the US where most of the money is in the equities and bond markets.

“If investors have a range of different, better investment instruments available to them, they won’t just deposit their money in the bank. Until there is better infrastructure in the finance market, I don’t think interest rate policy will be fully liberalized.”

Kam says a lack of transparency in the People’s Bank of China’s (PBoC) open market operations creates uncertainty with regard to secondary-market liquidity.

In addition to treasury bonds, policy banks – China Development Bank, Export-Import Bank and Agricultural Development Bank – issue around half of government debt to fund their operations.

The market is highly segmented between the interbank sector, which accounts for more than 90% of holdings but is closed to retail investors, and an exchange-based market that has dwindled into insignificance in the 15 years since the introduction of interbank trading.

There has been a raft of developments this year as part of Chinese regulators’ efforts to develop the market. The bond futures market is set to resume trading this month – 18 years after it was shuttered amid a trading scandal – after getting the go-ahead from the State Council and regulators.

Shanghai’s China Financial Futures Exchange (CFFEX) will launch trade with a single five-year contract with a RMB1 million face-value with price fluctuations capped at 2% up or down from the last settlement price. Bond futures offer improved price discovery and hedging facility to banks, dealers and investors.

Other reforms involve allowing foreign investors greater access to the bond market and removing restrictions on bank lending rates (mortgages excepted). The hope is that with banks able to lend on business terms, they will begin competing for business boosting lending to companies, particularly private firms previously denied access to affordable capital.

That seems overly optimistic given last year’s PBoC cut in the lending floor to 70% of its 6% benchmark has not led to cheaper loans.

However, all important deposit rates remain capped at 3.3%, which means that, in the absence of competition, hefty profits for banks are simply a case of funnelling savers’ capital into cheap, low-risk loans to large state-owned enterprises.

This structural bias against private and small and medium-sized enterprises forces them into obtaining funds – often at very high rates – in a vast shadow banking sector that rivals the government and corporate bonds markets combined.

S&P estimates the sector’s size at $3.7 trillion last year, but state firms sitting on piles of cash from cheap bank loans are up to their necks in shadow financing through issuance of entrusted loans and bankers’ acceptance notes, exposing banks’ ‘safe’ lending to risk of default.

In April, regulators cracked down hard on grey market trading on behalf of non-financial institutions in the interbank bond market.

Sara Hsu, an assistant economics professor at State University of New York, says the existence of this illegal trading between the primary and secondary markets illustrates the demand for a more developed bond market.

“However, the tough response of regulators shows it may be quite some time before China has a well-developed bond market,” she says.

“One of the main problems is poor bond issuers may endanger investors, so better education and education for investors is an absolute must. Very few corporations have gone through the default and restructuring process – the first occurred only in March on offshore bonds – and many investors believe the government will not allow default.”

She adds: “A properly functioning bond market would greatly help companies to access funds. Other entities would also like to access bonds but the scope of the bonds traded on the interbank secondary market is limited. A healthy secondary market would increase the flexibility of bonds and allow wider access to these funding instruments.

However, Hsu strongly cautions against rushing to open bond markets to foreign investors. “Any opening up would be a shock to China’s financial economy, and the financial structure must be strong and well-established before this takes place,” she says.