By Elliot Wilson
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China has spent the last 18 months marketing the hell out of the country’s bond markets, proclaiming the potential of mainland debt securities to pretty much anyone who will listen. There have been roadshows galore, many boasting keynote speeches from the world’s political and financial elite.
Barely a month goes by without news of yet another confab hosted by the People’s Bank of China. At times, China’s central bank seems, like Bruce Springsteen: perpetually on tour. Since the start of 2016, senior central bank officials have met a comprehensive cross-section of the world’s leading investors, in Geneva and London, New York and Tokyo, Singapore and Sydney.
At these events, they mingle with the likes of former US secretary of state Condoleezza Rice and listen to speeches from heads of state and titans of finance. And in each city and at every opportunity, they repeat the same mantra: that Chinese bonds are a great bet, long on yield, safe as houses and linked to the fortunes of an economy that is set, barring any big wobbles, to dominate the 21st century.
Eduardo Delascasas, China head of markets and securities services at Citi, accompanied the central bank on roadshows in Singapore, London and New York earlier this year. In Singapore, he says, more than 1000 investors showed up to listen to Ma Jun, before breaking off for group and one-on-one talks with the central bank’s chief economist.
At each session, says Delascasas, the same concerns were broached: “With the roadshow, the PBoC had the chance to meet hundreds of foreign institutional investors. Questions they fielded included the macro environment, the property bubble, non-performing loans in the banking sector and foreign exchange. Some talked to them about the tax regime for long-term bond investors. The central bank was impressed because interest was very high, very strong. It’s just a matter of time before the market really explodes, so investors are trying to figure out what is the correct time to get in.”
Every debt banker of note has much the same stories. The head of global markets for China at one leading international lender has attended four central bank roadshows since the start of 2016, visiting Tokyo, London, Taipei and Hong Kong. Further events are slated in the months ahead in Australia and the US.
“The beauty of these roadshows is the feedback,” he says. “Some US investors asked about trading hours. The bank listened to their concerns and extended trading on weekdays to 11.30pm. Concerns about the costs and risks of currency hedging were addressed too, if not always resolved. It showed how serious China is about getting its bond markets sorted out and fully opened.”
This hard sell is no accident. Beijing seldom does anything it deems unnecessary. When it decides on a course of action, it goes at it full tilt, until it meets its goal.
Thus, having determined that its future lay in trading with the world, it lobbied furiously to join the World Trade Organization. Likewise, a desire to create a powerful currency with global reach led it successfully to petition the IMF to include the renminbi in its basket of reserve currencies.
In the case of the bond markets, there are several drivers. Growth may be slowing, but Chinese GDP still expanded by $802 billion in 2016 – growth equivalent to the size of the entire Dutch economy. Once-parochial mainland corporates are morphing into global champions. On Forbes’ 2017 ranking of the largest 2,000 public firms, China accounted for 263 of the names, second only to the US.
And these firms are hungry. China’s banks extended a record Rmb12.65 trillion ($1.86 trillion) in loans in 2016, an annualized increase of 8%, yet leading mainland corporates still struggled to get their hands on enough working capital.
Beijing has never quite trusted the innate turbulence of its equity markets, alternately praising them when valuations rise, then jailing profit-seeking traders when prices fall.
The answer of course was staring Party leaders in the face.
“Chinese corporates are casting around for alternative sources of financing,” says Ben Quinlan, CEO and managing partner of Quinlan & Associates, a Hong Kong-based financial consultancy. “The bond markets are the obvious place to find the fresh capital they need,” he adds, especially as banks tighten their lending activity in the face of rising bad loans.
|Ben Quinlan, CEO and managing partner of Quinlan & Associates|
So it was that the world’s second-largest economy, a country that still heavily controls cross-border flows of capital, suddenly decided to throw open the door to investors of all stripes. Even veteran bond traders and bankers were shocked at the pace of change. In February 2016, the central bank, pledging to create “a more convenient and friendly environment” for investors, flung open the doors to the interbank bond market – which is where more than 90% of mainland debentures trade – to foreign institutions for the first time.
After years of begging to be given access to the market, foreign banks were suddenly handed the keys to the front door. In December 2016, Citi gained a Type A bond settlement agent licence, allowing the firm to buy, sell and settle bonds traded on the interbank market.
Two months later, JPMorgan Chase won approval to underwrite corporate debt in China’s interbank bond market.
The banks got what they wanted: Citi wanted a Type A licence, while JPMorgan was far more interested in gaining a sub-underwriting licence. This was an important development: Beijing rarely gives foreign interests what they want, unless it is in their interests to do so.
In May, Chinese premier Li Keqiang announced plans to roll out a bond connect scheme, along the lines of the cross-border share-trading scheme that links Hong Kong’s exchange with those in Shanghai and Shenzhen. Once the bond connect scheme is launched – and the most likely dates are either early July or in the autumn – foreign investors will be able to trade onshore Chinese bonds through their Hong Kong accounts, without the hassle of applying for a mainland account.
So far, the net result of this frenzied slashing of red tape has been strangely mixed. Banks allowed to operate in the market are, not surprisingly, giddy with exhilaration. China is at an “exciting stage of development,” says Alexi Chan, co-head of global debt capital markets at HSBC, which gained its own Type-A bond settlement agent licence in 2010. “It’s already the world’s third-largest bond market, with approximately $10 trillion equivalent worth of bonds outstanding. And with the ongoing opening up of China’s capital markets, we expect the bond market to develop in terms of scale and accessibility.”
He adds: “We are already seeing central banks and other official institutions reviewing their investment criteria to determine how they can increase their exposure to renminbi-denominated bonds.”
As China opens up, all eyes are turning to the big index operators. In January, Bloomberg included onshore bonds in its benchmark index for the first time. Citi then added domestic bonds to three of its sub-indices, but stopped short of including China in its World Government Bond Index, which had a market value of $20.3 trillion at the end of April.
It does, however, plan to create a WGBI-Extended index that includes the People’s Republic, yet leaves the main benchmark unchanged. Nor is China yet included in the other two important global bond indices: JPMorgan’s GBI-EM index, a key benchmark for emerging-market debt, and the Bloomberg Barclays Global Aggregate.
There are concerns about depreciation of the renminbi and rates are going up, so no one is in a hurry to enter into the market- Eduardo Delascasas, Citi
So long as China continues to open up its markets to foreign investors, while systematically stripping away interminable layers of capital controls, inclusion in the main bond indexes appears a formality. And when that happens, Chris Wood, equity strategist at CLSA, says it will be a “massively more important” event than the expected inclusion of China’s domestic A shares in the MSCI’s $1.5 trillion emerging-markets stock index on June 20.
Capital is widely expected to flood into onshore Chinese bonds.
The only question is, how much? Miranda Carr, senior analyst at Haitong Securities in London, tips $250 billion to be committed to Chinese bonds by foreign investors over the next three to five years.
After that, the size of the potential market is anyone’s guess. At the end of 2016, the amount of total outstanding US corporate bonds was $8.52 trillion, according to data from the Securities Industry and Financial Markets Association. Non-US investors accounted for 29% of that total, according to Morgan Stanley, or around $2.47 trillion, up from 12% of the total in 1990.
With China set to overtake the US as the world’s largest economy by 2030, and with its leading corporates only just beginning to find their global groove, its bond market clearly has the potential to become the world leader.
Ryan Song, head of global markets for China at HSBC, says foreign holdings of Chinese bonds as a share of the market “can easily go to 5% or 6% of the total within two years… which means foreign holdings can easily increase to $1.1 trillion.”
Bankers believe the onshore bond market has the capacity to double in size over the next five to 10 years, becoming a $10 trillion market.
None of this, of course, is inevitable. There will always be speed bumps along the way, particularly on a project of this scale. So far at least, China’s charm offensive has been only partially effective. It has relaxed rules and used its tame state media to trumpet the benefits of buying mainland bonds.
For their part, investment managers at pension funds, sovereign wealth funds, central banks, supranationals and non-profit endowments have happily showed up at the central bank’s roadshows to rub shoulders and ask pointed questions.
But what isn’t clear yet is whether or not any of them are willing to actually buy these bonds. Foreign ownership of Chinese domestic bonds rose in 2016, but by just 13% on an annualized basis. Given the level of global interest in the asset class stemming from last year’s welter of rule changes, Beijing should have posted a far higher bump in sales. At the end of 2016, foreign holdings of Chinese domestic bonds was Rmb853 billion, or 1.3% of the total market value, down from 1.6% at the end of 2015 and 1.9% at the end of 2014.
|Alexi Chan, HSBC|
There are many reasons for these poor figures and for the vacillation so many foreign investors clearly feel when they consider Chinese bonds, but they can be boiled down to three.
First up is the poor structural state of China’s economy, which can be further broken down into a host of splinter concerns. Beijing expects GDP to expand by around 6.7% this year. But some nasty surprises lurk below the surface. Debt levels are rising everywhere – at banks, which have long underreported bad loans, at the provincial and local government level and at the corporate level.
The latter is the key issue here: corporate debt at the end of 2016 was 170% of GDP, according to the Bank of International Settlements, nearly double the level eight years ago and around twice the level in most big economies.
Non-financial debt, as a whole, hit 277% of GDP at the end of 2015, up from 150% at the start of the 2008 financial crisis. Efforts by Zhou Xiaochuan, central bank governor, to rein in excess leverage have pushed up yields and led to a sharp dip in onshore corporate bond sales, which fell to $117.6 billion (spanning 611 prints) in the first quarter of 2017, against $279.2 billion (1,362 prints) in the same period a year ago, according to data from Dealogic.
Ratings agencies have taken note. Moody’s Investors Service in May clipped its rating on China’s sovereign credit by a single notch – the country’s first downgrade in three decades – citing fears that excessive leverage was harming the country’s financial health.
This goes some way to explaining why foreign funds have been so slow to snap up local bonds. The macro situation “is not helping,” says Citi’s Delascasas. “There are concerns about depreciation of the renminbi and rates are going up, so no one is in a hurry to enter into the market. Investors know it will become relevant – it’s just a matter of when – so for many of them the key is to be prepared.”
China’s renminbi lost 6% of its value against the US dollar in 2016, though it has bounced back a bit this year.
But these are problems with actual solutions. China has tackled debt crises before, albeit often by shuffling its various liabilities from one pocket to another. Growth rates remain solid, the tax system is efficiently run, and jobless rates are low.
Citi’s Delascasas reckons that, barring unforeseen bumps in the road – sharply slowing growth, regulatory missteps – foreign ownership of mainland bonds could reach, or even exceed, 10% of the total by 2022. “The market’s huge potential is clearly there,” he adds.
Problem number two is the underlying state of some mainland enterprises. China boasts some world-class multinationals, but has plenty of duds in the corporate sector. Too many state-owned enterprises and many private-sector firms are badly run, yet for years, Beijing was reluctant to allow any large firm to fold, fearing job losses and instability. The first corporate default only took place in 2015, when a privately run maker of solar panels, Shanghai Chaori, was allowed to fail to meet its loan repayments. Before then, bailouts were the norm.
Shanghai Chaori set a trend – the number of defaults has risen fast. In 2016, 29 firms defaulted on their bonds, according to data from Dealogic. Another 13 corporates defaulted in the first five months of this year. These include the failure by Dalian Machine Tool Group, an industrial outfit from the rustbelt reaches of northeastern China, to repay Rmb543 million in principal and interest on its privately placed notes, on May 20.
Some experts rightly see Beijing’s decision to allow some failing firms to default on their debt in a calm and orderly manner as a positive sign.
“The development of a well-functioning credit market requires some level of credit stress and inevitably some defaults, and that is part and parcel of bringing market forces to bear in a country,” notes one Hong Kong-based debt markets banker. “So some credit stress, and some defaults, are to be embraced. It’s a positive thing.”
But the authorities are far more reticent about allowing the same market-oriented sensibilities to permeate the public sector. Precious few state firms have ever been allowed to default, let alone flirt with bankruptcy; the authorities would rather bail them out than see them fail.
In an editorial published on May 25, the state-run China Daily said that troubled SOEs should, wherever possible, be “reorganized” [read: bailed out]. “Such measures,” it added, were “necessary for the stability of the economy and the progress of the market.”
This creates a quandary. China’s ratings agencies will always view SOEs as more credit-worthy than private firms because they believe the state will always ride to the rescue. But this is bad for everyone – for government, for the company and for bondholders. It means there is no real incentive for a company to radically transform its fortunes and its finances, while from the bondholder perspective, vulture funds aside, who really wants to own the debt of a zombie SOE?
Going all the way
Finally, there is the elephant in the room. That China is serious about opening its doors to foreign investors is beyond doubt.
“In the long term, the process of promoting onshore debt securities is more strategic and part of China’s determination to become a major and globally relevant financial economy,” says Citi’s Delascasas.
Beijing, he adds, wants the yuan to become a “serious international currency, and to achieve that, you need broad and deep capital markets. And if you are going to hold renminbi, first and foremost the best place to put it to work is in the bond markets.”
Thus, everything connects. A deeper and better-run domestic bond market, seamlessly woven into international capital markets, boosts the prospects of a more globalized renminbi, and vice versa.
|Chris Wood, equity strategist at CLSA|
But will China really go all the way? What would happen if, say, global investors, having fallen in love with mainland bonds, were spooked and decided to dump all their holdings. Would Beijing really let them?
It’s a valid question. Between October 2015 and the end of May 2017, China’s foreign exchange reserves fell by more than $500 billion, according to data from the State Administration of Foreign Exchange. By some estimates, $3.8 trillion in capital has fled China over the past decade, while just $1.3 trillion in net FDI has made the reverse journey. To some extent, Beijing’s rush to roll out the red carpet to bond investors is, says Citi’s Delascasas, a tacit recognition that it “does need to counterbalance some of those outflow.”
Capital flight has actually compelled authorities to add a few layers of capital controls, rather than peeling them away. Multinationals, some of which have had offices and factories in China for decades, tell of difficulties in repatriating profits. This, bankers note, has led to foreign companies keeping capital out of the country and choosing to raise debt onshore to fund local operations, rather than doing inter-company loans.
Beijing is doing “everything in its power to slow renminbi outflows,” says Quinlan: “Capital restrictions – limits on repatriation of capital – will always be the big issue for foreign investors.”
One China-focused debt markets banker says Beijing’s attitude was “at times fundamentally contradictory. On the one hand, as you can see with the example of the bond markets, they desperately want to attract capital. But when it comes to other forms of capital, they are desperate to stop it leaving. It’s a worry for corporates, but it is also one of the key concerns among foreign investors. They ask: ‘If we put our money to work here, will we be able to take it out again?’”
CLSA’s Wood connects this fear to the question of whether or not paper issued by Chinese companies should be included in global bond indexes.
“Sceptics,” he says, “will wonder how China can ever be included in major benchmark indices, given that the nature of the system makes it unlikely in the extreme that China will ever give foreign investors complete freedom to sell bonds.”
Wood admits that this is an extreme conclusion, but it is a genuine concern, and one that will, for the foreseeable future – and for all Beijing’s soothing words about being pro-market and anti-capital restrictions and a friend to the debt markets – keep bond traders up at night.
The authorities will likely spend years fighting fires and dealing with investor grievances. China is, after all, attempting to build a fully functioning and globally linked debt market without first opening its capital account or boasting a full and freely convertible currency.
One of the biggest gripes at present is that it takes too long to be approved as a foreign investor and to be allowed to buy and sell bonds at will.
“There is no quota system, since the central bank did away with those rules last year,” says one Hong Kong fund manager. “But the filing process is cumbersome and takes months. It should be simpler, and a good start would be a website that also has all the right documentation in English.”
Beijing hopes that such grievances will come to be seen as minor quibbles: part and parcel of the hellish complexity of transforming a parochial bond market into one of genuine complexity, global reach and sophistication. After all, in theory China has everything a bond investor needs: decent yields and a solid range of corporates, many boasting global ambitions and tied to the fortunes of an economy well on the way to becoming the world’s largest.
Investors are likely to tread carefully at first, starting out, says HSBC’s Song, “by investing in (investment grade-rated) products first, so 95% of their holdings will be government and policy bonds. And as they become more comfortable, they can move down the credit curve.”
Quinlan contrasts China’s manifest potential, “where the institutional investor space is growing rapidly and profitably”, with Europe, where “asset managers are crippled or are consolidating, and hedge funds are shutting down.”
He adds that the constraints of the secondary market, which remains illiquid because investors prefer to hold bonds to maturity on their balance sheets, will push mainland firms to issue primary bonds to sate demand.
Regulators meanwhile will continue to “encourage corporates and financial providers to create, invent and roll out more unusual types of bond structures and new paper. Demand from this perspective will be explosive.”
This is a market that will engage the interest of global investors, for better or worse, and sometimes both, for years to come.